14.4: International Trade Agreements & Organizations

14.4.1: Common Markets

Learning Objective

Explain the history of the European Economic Community (EEC)

Key Points

• A common market is the first stage towards a single market and may be limited initially to a free trade area, with relatively free movement of capital and of services. However, it is not to a stage where the remaining trade barriers have been eliminated.
• The European Economic Community (EEC) (also known as the Common Market in the English-speaking world and sometimes referred to as the European Community even before it was renamed as such in 1993) was an international organization created by the 1957 Treaty of Rome.
• The main aim of the EEC, as stated in its preamble, was to “preserve peace and liberty and to lay the foundations of an ever closer union among the peoples of Europe”.

Key Term

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

Example

• The European Economic Community was the first example of a both common and single market, but it was an economic union since it had additionally a customs union. The European Economic Community (EEC) was an international organization created by the 1957 Treaty of Rome. Its aim was to bring about economic integration, including a common market, among its six founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands. Upon the entry into force of the Maastricht Treaty in 1993, the EEC was renamed the European Community (EC) to reflect that it covered a wider range of policy. This was also when the three European Communities, including the EC, were collectively made to constitute the first of the three pillars of the European Union (EU). For the customs union, the treaty provided for a 10% reduction in custom duties and up to 20% of global import quotas. Progress on the customs union proceeded much faster than the twelve years planned.

A common market is a first stage towards a single market and may be limited initially to a free trade area with relatively free movement of capital and of services, but not so advanced in reduction of the rest of the trade barriers.

The European Economic Community (EEC) (also known as the Common Market in the English-speaking world and sometimes referred to as the European Community even before it was renamed as such in 1993) was an international organization created by the 1957 Treaty of Rome. Its aim was to bring about economic integration, including a common market, among its six founding members: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands.

It gained a common set of institutions along with the European Coal and Steel Community (ECSC) and the European Atomic Energy Community (EURATOM) as one of the European Communities under the 1965 Merger Treaty (Treaty of Brussels).

Upon the entry into force of the Maastricht Treaty in 1993, the EEC was renamed the European Community (EC) to reflect that it covered a wider range of policy. This was also when the three European Communities, including the EC, were collectively made to constitute the first of the three pillars of the European Union (EU), which the treaty also founded. The EC existed in this form until it was abolished by the 2009 Treaty of Lisbon, which merged the EU’s former pillars and provided that the EU would “replace and succeed the European Community. ” The main aim of the EEC, as stated in its preamble, was to “preserve peace and liberty and to lay the foundations of an ever closer union among the peoples of Europe. ” Calling for balanced economic growth, this was to be accomplished through:

• The establishment of a customs union with a common external tariff
• Common policies for agriculture, transport, and trade
• Enlargement of the EEC to the rest of Europe

For the customs union, the treaty provided for a 10% reduction in custom duties and up to 20% of global import quotas. Progress on the customs union proceeded much faster than the 12 years planned. However, France faced some setbacks due to its war with Algeria.

The six states that founded the EEC and the other two communities were known as the “inner six” (the “outer seven” were those countries who formed the European Free Trade Association). The six were France, West Germany, Italy, and the three Benelux countries: Belgium, the Netherlands, and Luxembourg. The first enlargement was in 1973, with the accession of Denmark, Ireland, and the United Kingdom. Greece, Spain, and Portugal joined in the 1980s. Following the creation of the EU in 1993, it has enlarged to include an additional 15 countries by 2007.

There were three political institutions that held the executive and legislative power of the EEC, plus one judicial institution and a fifth body created in 1975. These institutions (except for the auditors) were created in 1957 by the EEC but from 1967 on, they applied to all three communities. The council represents governments, the Parliament represents citizens, and the commission represents the European interest.

European Economic Community

Original member states (blue) and later members (green)

14.4.2: The Export-Import Bank of the United States

Learning Objective

Explain the purpose of the Export-Import Bank of the United States (Ex-Im Bank)

Key Points

• The mission of the Ex-Im Bank is to create and sustain U.S. jobs by financing sales of U.S. exports to international buyers.
• Ex-Im Bank provides financing for transactions that would otherwise not take place because commercial lenders are either unable or unwilling to accept the political or commercial risks inherent in the deal.
• The Export-Import Bank of the United States focuses much of its energy and resources on providing support to U.S. small businesses for export of American-made products.
• Export Credit Insurance from Export-Import Bank of the United States provides insurance policies to U.S. companies and banks to mitigate risks of non-collection from foreign buyers and borrowers.
• The Working Capital Guarantee program provides loan guarantees to banks willing to lend to exporting companies.

Key Terms

risk

To incur risk [of something].

guarantee

To assume responsibility for a debt.

credit agency

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.

Example

• The Ex-Im Bank provides two types of loans: direct loans to foreign buyers of American exports and intermediary loans to responsible parties, such as foreign government lending agencies that re-lend to foreign buyers of capital goods and related services (for example, a maintenance contract for a jet passenger plane).

The Export-Import Bank of the United States (Ex-Im Bank) is the official export credit agency of the United States federal government. It was established in 1934 by an executive order and made an independent agency in the Executive branch by Congress in 1945. Its purpose is to finance and insure foreign purchases of United States goods for customers unable or unwilling to accept credit risk.

The mission of the Ex-Im Bank is to create and sustain U.S. jobs by financing sales of U.S. exports to international buyers. Ex-Im Bank is the principal government agency responsible for aiding the export of American goods and services through a variety of loan, guarantee, and insurance programs. Generally, its programs are available to any American export firm regardless of size. The Bank is chartered as a government corporation by the Congress of the United States; it was last chartered for a five year term in 2006. Its Charter spells out the Bank’s authorities and limitations. Among them is the principle that Ex-Im Bank does not compete with private sector lenders, but rather provides financing for transactions that would otherwise not take place because commercial lenders are either unable or unwilling to accept the political or commercial risks inherent in the deal.

Export-Import Bank of the United States

Seal of the Export-Import Bank of the United States.

Ex-Im Bank provides the following services:

• The Export-Import Bank of the United States focuses much of its energy and resources on providing support to small American businesses for export of American-made products
• Export Credit Insurance provides insurance policies to U.S. companies and banks to mitigate risks of non-collection from foreign buyers and borrowers.
• The Working Capital Guarantee program provides loan guarantees to banks willing to lend to exporting companies.
• Two types of loans: direct loans to foreign buyers of American exports and intermediary loans to responsible parties, such as foreign government lending agencies that re-lend to foreign buyers of capital goods and related services (for example, a maintenance contract for a jet passenger plane).

14.4.3: The International Monetary Fund (IMF)

Learning Objective

Explain how the International Monetary Fund (IMF) aids its 188 member countries

Key Points

• The International Monetary Fund (IMF) is an international organization that was created on July 22, 1944 at the Bretton Woods Conference.
• The IMF’s stated goal is to stabilize exchange rates and assist the reconstruction of the world’s international payment system after World War II.
• The IMF is run by country contributions. Money is pooled through a quota system from which countries with payment imbalances can borrow funds on a temporary basis.
• It works with developing nations to help them achieve macroeconomic stability and reduce poverty. The rationale for this is that private international capital markets function imperfectly and many countries have limited access to financial markets. Such market imperfections, together with balance of payments financing, provide the justification for official financing, without which many countries could only correct large external payment imbalances through measures with adverse effects on both national and international economic prosperity. The IMF can provide other sources of financing to countries in need that would not be available in the absence of an economic stabilization program supported by the Fund.
• Member countries of the IMF have access to information on the economic policies of all member countries, the opportunity to influence other members’ economic policies, technical assistance in banking, fiscal affairs, and exchange matters, financial support in times of payment difficulties, and increased opportunities for trade and investment. IMF conditionality is a set of policies that the IMF requires in exchange for financial resources. The IMF does not require collateral from countries for loans but rather requires the government seeking assistance to correct its macroeconomic imbalances in the form of policy reform. If the conditions are not met, the funds are withheld. Conditionality is perhaps the most controversial aspect of IMF policies.
• These loan conditions ensure that the borrowing country will be able to repay the Fund and that the country won’t attempt to solve their balance of payment problems in a way that would negatively impact the international economy. The incentive problem of moral hazard, which is the actions of economic agents maximizing their own utility to the detriment of others when they do not bear the full consequences of their actions, is mitigated through conditions rather than providing collateral; countries in need of IMF loans do not generally possess internationally valuable collateral anyway. Conditionality also reassures the IMF that the funds lent to them will be used for the purposes defined by the Articles of Agreement and provides safeguards that country will be able to rectify its macroeconomic and structural imbalances. In the judgment of the Fund, the adoption by the member of certain corrective measures or policies will allow it to repay the Fund, thereby ensuring that the same resources will be available to support other members.
• Voting power in the IMF is, like the money pool, based on a quota system. Each member has a number of “basic votes” (each member’s number of basic votes equals 5.502% of the total votes), plus one additional vote for each Special Drawing Right (SDR) of 100,000 of a member country’s quota. The Special Drawing Right is the unit of account of the IMF and represents a claim to currency. It is based on a basket of key international currencies. The basic votes generate a slight bias in favor of small countries, but the additional votes determined by SDR outweigh this bias.
• The IMF is mandated to oversee the international monetary and financial system and monitor the economic and financial policies of its 188 member countries. This activity is known as surveillance and facilitates international cooperation. Since the demise of the Bretton Woods system of fixed exchange rates in the early 1970s, surveillance has evolved largely by way of changes in procedures rather than through the adoption of new obligations. The responsibilities of the Fund changed from those of guardian to those of overseer of members’ policies.
• Some critics assume that Fund lending imposes a burden on creditor countries. However, countries receive market-related interest rates on most of their quota subscription, plus any of their own-currency subscriptions that are loaned out by the Fund, plus all of the reserve assets that they provide the Fund. Also, as of 2005 borrowing countries have had a very good track record of repaying credit extended under the Fund’s regular lending facilities with the full interest over the duration of the borrowing.

Key Terms

collateral

A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )

capital market

The market for long-term securities, including the stock market and the bond market.

moral hazard

The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

The International Monetary Fund (IMF) is an international organization that was created on July 22, 1944 at the Bretton Woods Conference and came into existence on December 27, 1945 when 29 countries signed the IMF Articles of Agreement. It originally had 45 members. The IMF’s stated goal was to stabilize exchange rates and assist the reconstruction of the world’s international payment system post-World War II. Countries contribute money to a pool through a quota system from which countries with payment imbalances can borrow funds on a temporary basis. Through this activity and others, such as surveillance of its members’ economies and policies, the IMF works to improve the economies of its member countries. The IMF describes itself as “an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty. “

The organization’s stated objectives are to promote international economic cooperation, international trade, employment, and exchange rate stability, including by making financial resources available to member countries to meet balance of payments needs. Member countries of the IMF have access to information on the economic policies of all member countries, the opportunity to influence other members’ economic policies, technical assistance in banking, fiscal affairs, and exchange matters, financial support in times of payment difficulties, and increased opportunities for trade and investment. Voting power in the IMF is based on a quota system. Each member has a number of “basic votes” (each member’s number of basic votes equals 5.502% of the total votes), plus one additional vote for each Special Drawing Right (SDR) of 100,000 of a member country’s quota. The Special Drawing Right is the unit of account of the IMF and represents a claim to currency. It is based on a basket of key international currencies. The basic votes generate a slight bias in favor of small countries, but the additional votes determined by SDR outweigh this bias.

The IMF works to foster global growth and economic stability. It provides policy advice and financing to members in economic difficulties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty. The rationale for this is that private international capital markets function imperfectly, and many countries have limited access to financial markets. Such market imperfections, together with balance of payments financing, provide the justification for official financing, without which many countries could only correct large external payment imbalances through measures with adverse effects on both national and international economic prosperity. The IMF can provide other sources of financing to countries in need that would not be available in the absence of an economic stabilization program supported by the fund.

The IMF is mandated to oversee the international monetary and financial system and monitor the economic and financial policies of its 188 member countries. This activity is known as “surveillance” and facilitates international cooperation. Since the demise of the Bretton Woods system of fixed exchange rates in the early 1970s, surveillance has evolved largely by way of changes in procedures rather than through the adoption of new obligations.The responsibilities of the fund changed from those of guardian to those of overseer of members’ policies. The fund typically analyzes the appropriateness of each member country’s economic and financial policies for achieving orderly economic growth, and assesses the consequences of these policies for other countries and for the global economy.

IMF conditionality is a set of policies or “conditions” that the IMF requires in exchange for financial resources. The IMF does not require collateral from countries for loans but rather requires the government seeking assistance to correct its macroeconomic imbalances in the form of policy reform. If the conditions are not met, the funds are withheld. Conditionality is the most controversial aspect of IMF policies. These loan conditions ensure that the borrowing country will be able to repay the fund and that the country won’t attempt to solve their balance of payment problems in a way that would negatively impact the international economy. The incentive problem of moral hazard, which is the actions of economic agents maximizing their own utility to the detriment of others when they do not bear the full consequences of their actions, is mitigated through conditions rather than providing collateral; countries in need of IMF loans do not generally possess internationally valuable collateral anyway. Conditionality also reassures the IMF that the funds lent to them will be used for the purposes defined by the Articles of Agreement and provides safeguards that country will be able to rectify its macroeconomic and structural imbalances. In the judgment of the fund, the adoption by the member of certain corrective measures or policies will allow it to repay the fund, thereby ensuring that the same resources will be available to support other members.

IMF Headquarters

Washington, DC headquarters of the IMF

14.4.4: The North American Free Trade Agreement (NAFTA)

Learning Objective

Outline the stipulations of NAFTA

Key Points

• The North American Free Trade Agreement (NAFTA) is an agreement signed by the governments of Canada, Mexico, and the United States, creating a trilateral trade bloc in North America.
• NAFTA came into effect on January 1, 1994 and superseded the Canada – United States Free Trade Agreement.
• Within 10 years of the implementation of NAFTA, all U.S.-Mexico tariffs are to be eliminated except for some U.S. agricultural exports to Mexico which will be phased out within 15 years.
• Most U.S. – Canada trade was duty free before NAFTA.
• NAFTA also seeks to eliminate non-tariff trade barriers and to protect the intellectual property right of the products.
• When viewing the combined GDP of its members, as of 2010 NAFTA is the largest trade bloc in the world.

Key Terms

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

trade bloc

A trade bloc is a type of intergovernmental agreement, often part of a regional intergovernmental organization, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated among the participating states.

The North American Free Trade Agreement (NAFTA)

The North American Free Trade Agreement (NAFTA) is an agreement signed by the governments of Canada, Mexico, and the United States, creating a trilateral trade bloc in North America. The agreement came into force on January 1, 1994. It superseded the Canada – United States Free Trade Agreement between the U.S. and Canada.

In terms of combined GDP of its members, the trade bloc is the largest in the world as of 2010. NAFTA has two supplements: the North American Agreement on Environmental Cooperation (NAAEC) and the North American Agreement on Labor Cooperation (NAALC). The goal of NAFTA was to eliminate barriers to trade and investment among the U.S., Canada, and Mexico.

The implementation of NAFTA on January 1, 1994 brought the immediate elimination of tariffs on more than one-half of Mexico’s exports to the U.S. and more than one-third of U.S. exports to Mexico. Within 10 years of the implementation of the agreement, all U.S.–Mexico tariffs would be eliminated except for some U.S. agricultural exports to Mexico that were to be phased out within 15 years. Most U.S.–Canada trade was already duty free. NAFTA also seeks to eliminate non-tariff trade barriers and to protect the intellectual property right of the products.

The agreement opened the door for open trade, ending tariffs on various goods and services, and implementing equality between Canada, America, and Mexico. NAFTA has allowed agricultural goods such as eggs, corn, and meats to be tariff-free. This allowed corporations to trade freely and import and export various goods on a North American scale .

NAFTA countries

The members of NAFTA are the U.S., Canada, and Mexico.

14.4.5: The World Bank

Learning Objective

Explain the role played by the World Bank in reducing poverty

Key Points

• The World Bank’s official goal is the reduction of poverty.
• According to the World Bank’s Articles of Agreement, all of its decisions must be guided by a commitment to promote foreign investment, international trade, and facilitate capital investment.
• The current President of the Bank, Jim Yong Kim, is responsible for chairing the meetings of the boards of directors and for overall management of the bank.
• Traditionally, the bank president has always been a U.S. citizen nominated by the United States, the largest shareholder in the bank. The nominee is subject to confirmation by the board of executive directors, to serve for a five-year, renewable term.
• For the poorest developing countries in the world, the bank’s assistance plans are based on poverty reduction strategies.

Key Terms

developing

Of a country: becoming economically more mature or advanced; becoming industrialized.

loan

A sum of money or other valuables or consideration that an individual, group, or other legal entity borrows from another individual, group, or legal entity (the latter often being a financial institution) with the condition that it be returned or repaid at a later date (sometimes with interest).

poverty

The quality or state of being poor or indigent; want or scarcity of means of subsistence; indigence; need.

World Bank

a group of five financial organizations whose purpose is economic development and the elimination of poverty

The World Bank is an international financial institution that provides loans to developing countries for capital programs. The World Bank’s official goal is the reduction of poverty. According to the World Bank’s Articles of Agreement (as amended effective February 16,1989), all of its decisions must be guided by a commitment to promote foreign investment, international trade, and facilitate capital investment.

The World Bank differs from the World Bank Group, in that the World Bank comprises only two institutions: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), whereas the former incorporates these two in addition to three more: International Finance Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and International Centre for Settlement of Investment Disputes (ICSID). The curent President of the Bank, Jim Yong Kim, is responsible for chairing the meetings of the boards of directors and for overall management of the bank. Traditionally, the bank president has always been a U.S. citizen nominated by the United States, the largest shareholder in the bank. The nominee is subject to confirmation by the board of executive directors, to serve for a five-year, renewable term.

The International Bank for Reconstruction and Development (IBRD) has 188 member countries, while the International Development Association (IDA) has 172 members.Each member state of IBRD should be also a member of the International Monetary Fund (IMF), and only members of IBRD are allowed to join other institutions within the Bank (such as IDA).

For the poorest developing countries in the world, the bank’s assistance plans are based on poverty reduction strategies; by combining a cross-section of local groups with an extensive analysis of the country’s financial and economic situation, the World Bank develops a strategy pertaining uniquely to the country in question. The government then identifies the country’s priorities and targets for the reduction of poverty, and the World Bank aligns its aid efforts correspondingly. Forty-five countries pledged $25.1 billion in “aid for the world’s poorest countries,” aid that goes to the World Bank International Development Association (IDA) which distributes the loans to 80 poorer countries.

World Bank Headquarters

Washington, DC headquarters of the World Bank

14.4.6: The European Union

Learning Objective

Discuss the establishment of the European Union (EU) and the Euro

Key Points

• The European Union (EU) is an economic and political union made up of 27 member states that are located primarily in Europe.
• Members of the EU include Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.
• The EU operates through a system of supranational independent institutions and intergovernmental negotiated decisions by the member states.
• Within the Schengen Area (which includes EU and non-EU states) passport controls have been abolished.
• The creation of a single currency became an official objective of the European Economic Community (EEC) in 1969. On January 1, 2002 euro notes and coins were issued and national currencies began to phase out in the eurozone.
• The ECB is the central bank for the eurozone, and thus controls monetary policy in that area with an agenda to maintain price stability. It is at the center of the European System of Central Banks, which comprises all EU national central banks and is controlled by its General Council, consisting of the President of the ECB, who is appointed by the European Council, the Vice-President of the ECB, and the governors of the national central banks of all 27 EU member states.

Key Terms

European Union

A supranational organization created in the 1950s to bring the nations of Europe into closer economic and political connection. At the beginning of 2012, 27 member nations were Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, The Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom.

euro

The currency unit of the European Monetary Union. Symbol: €

transparency

Open, public; having the property that theories and practices are publicly visible, thereby reducing the chance of corruption.

Example

• The euro is designed to help build a single market by easing travel of citizens and goods, eliminating exchange rate problems, providing price transparency, creating a single financial market, stabilizing prices, maintaining low interest rates, and providing a currency used internationally and protected against shocks by the large amount of internal trade within the eurozone. It is also intended as a political symbol of integration.

The European Union

The European Union (EU) is an economic and political union or confederation of 27 member states that are located in Europe, including:

Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.

The EU operates through a system of supranational independent institutions and intergovernmental decisions negotiated by the member states. Important institutions of the EU include the European Commission, the Council of the European Union, the European Council, the Court of Justice of the European Union, and the European Central Bank. The European Parliament is elected every five years by EU citizens. The EU has developed a single market through a standardized system of laws that apply in all member states. Within the Schengen Area (which includes EU and non-EU states) passport controls have been abolished. EU policies aim to ensure the free movement of people, goods, services, and capital, enact legislation in justice and home affairs, and maintain common policies on trade, agriculture, fisheries, and regional development. A monetary union, the eurozone, was established in 1999, and as of January 2012, is composed of 17 member states. Through the Common Foreign and Security Policy the EU has developed a limited role in external relations and defense. Permanent diplomatic missions have been established around the world. The EU is represented at the United Nations, the WTO, the G8 and the G-20.

The Euro

The creation of a single European currency became an official objective of the European Economic Community in 1969. However, it was only with the advent of the Maastricht Treaty in 1993 that member states were legally bound to start the monetary union. In 1999 the euro was duly launched by eleven of the then fifteen member states of the EU. It remained an accounting currency until 1 January 2002, when euro notes and coins were issued and national currencies began to phase out in the eurozone, which by then consisted of twelve member states. The eurozone (constituted by the EU member states that have adopted the euro) has since grown to seventeen countries, the most recent being Estonia, which joined on 1 January 2011. All other EU member states, except Denmark and the United Kingdom, are legally bound to join the euro when the convergence criteria are met, however only a few countries have set target dates for accession. Sweden has circumvented the requirement to join the euro by not meeting the membership criteria.

The euro is designed to help build a single market by easing travel of citizens and goods, eliminating exchange rate problems, providing price transparency, creating a single financial market, stabilizing prices, maintaining low interest rates, and providing a currency used internationally and protected against shocks by the large amount of internal trade within the eurozone. It is also intended as a political symbol of integration. The euro and the monetary policies of those who have adopted it in agreement with the EU are under the control of the European Central Bank (ECB). The ECB is the central bank for the eurozone, and thus controls monetary policy in that area with an agenda to maintain price stability. It is at the center of the European System of Central Banks, which comprises all EU national central banks and is controlled by its General Council, consisting of the President of the ECB, who is appointed by the European Council, the Vice-President of the ECB, and the governors of the national central banks of all 27 EU member states. The monetary union has been shaken by the European sovereign-debt crisis since 2009.

European Union

European Union member countries

14.4.7: The Asia-Pacific Economic Cooperation

Learning Objective

Explain the role The Asia-Pacific Economic Cooperation (APEC ) plays in ensuring free trade

Key Points

• Asia-Pacific Economic Cooperation (APEC) is a forum for 21 Pacific Rim countries that seeks to promote free trade and economic cooperation.
• APEC was established in 1989 in response to the growing interdependence of Asia-Pacific economies and the advent of regional economic blocs.
• APEC member countries include Australia, Brunei, Canada, Chile, China, Hong Kong (Hong Kong, China), Indonesia, Japan, South Korea, Mexico, Malaysia, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Taiwan (Chinese Taipei), Thailand, United States, and Vietnam.
• During the meeting in 1994 in Bogor, Indonesia, APEC leaders adopted the Bogor Goals which aim for free and open trade and investment in the Asia-Pacific by 2010, for industrialized economies and by 2020, for developing economies.

Key Term

bloc

A group of countries acting together for political or economic goals, an alliance (e.g., the eastern bloc, the western bloc, a trading bloc).

The Asia-Pacific Economic Cooperation (APEC) is a forum for 21 Pacific Rim countries (formally Member Economies) that seeks to promote free trade and economic cooperation throughout the Asia-Pacific region. Established in 1989 in response to the growing interdependence of Asia-Pacific economies and the advent of regional economic blocs (such as the European Union) in other parts of the world, APEC works to raise living standards and education levels through sustainable economic growth and to foster a sense of community and an appreciation of shared interests among Asia-Pacific countries.

Member countries are: Australia, Brunei, Canada, Chile, China, Hong Kong (Hong Kong, China), Indonesia, Japan, South Korea, Mexico, Malaysia, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Taiwan (Chinese Taipei), Thailand, United States, and Vietnam.

APEC member countries

APEC’s member countries border both the east and the west of the Pacific Ocean.

During the meeting in 1994 in Bogor, Indonesia, APEC leaders adopted the Bogor Goals that aim for free and open trade and investment in the Asia-Pacific by 2010, for industrialized economies and by 2020, for developing economies. In 1995, APEC established a business advisory body named the APEC Business Advisory Council (ABAC), composed of three business executives from each member economy. To meet the Bogor Goals, APEC carries out work in three main areas:

1. Trade and investment liberalization
2. Business facilitation
3. Economic and technical cooperation

APEC is considering the prospects and options for a Free Trade Area of the Asia-Pacific (FTAAP), which would include all APEC member economies. Since 2006, the APEC Business Advisory Council, promoting the theory that a free trade area has the best chance of converging the member nations and ensuring stable economic growth under free trade, has lobbied for the creation of a high-level task force to study and develop a plan for a free trade area. The proposal for a FTAAP arose due to the lack of progress in the Doha round of World Trade Organization negotiations, and as a way to overcome the “spaghetti bowl” effect created by overlapping and conflicting elements of the umpteen free trade agreements. There are approximately 60 free trade agreements, with an additional 117 in the process of negotiation in Southeast Asia and the Asia-Pacific region.

14.4.8: The General Agreement on Tariffs and Trade (GATT)

Learning Objective

Outline the history of the creation of the General Agreement on Tariffs and Trade (GATT)

Key Points

• The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement regulating international trade, the purpose of which is the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis”.
• The failure to create the International Trade Organization (ITO) resulted in the GATT negotiation at the UN Conference on Trade and Employment.
• GATT was in place from 1947-1993, when it was replaced by the World Trade Organization (WTO) in 1995.
• GATT text is still in effect under the WTO framework, subject to modifications.
• During GATT’s eight rounds, countries exchanged tariff concessions and reduced tariffs.

Key Terms

multilateral

Involving more than one party (often used in politics to refer to negotiations, talks, or proceedings involving several nations).

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement regulating international trade. According to its preamble, its purpose is the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis. ” GATT was negotiated during the UN Conference on Trade and Employment and was the outcome of the failure of negotiating governments to create the International Trade Organization (ITO). GATT was signed in 1947 and lasted until 1993, when it was replaced by the World Trade Organization (WTO) in 1995. The original GATT text (GATT 1947) is still in effect under the WTO framework, subject to the modifications of GATT 1994.

GATT held a total of eight rounds, during which countries exchanged tariff concessions and reduced tariffs.

In 1993, the GATT was updated (GATT 1994) to include new obligations upon its signatories. One of the most significant changes was the creation of the WTO. The 75 existing GATT members and the European Communities became the founding members of the WTO on January 1, 1995. The other 52 GATT members rejoined the WTO in the following two years, the last being Congo in 1997. Since the founding of the WTO, 21 new non-GATT members have joined and 29 are currently negotiating membership. There are a total of 157 member countries in the WTO, with Russia and Vanuatu being new members as of 2012.

Of the original GATT members, Syria and SFR Yugoslavia (SFRY) have not rejoined the WTO. Because FR Yugoslavia (later renamed Serbia and Montenegro) is not recognized as a direct SFRY successor state, its application is considered a new (non-GATT) one. The General Council of WTO, on 4 May 2010, agreed to establish a working party to examine the request of Syria for WTO membership. The contracting parties who founded the WTO ended official agreement of the “GATT 1947” terms on 31 December 1995. Serbia and Montenegro are in the decision stage of the negotiations and are expected to become the newest members of the WTO in 2012 or in the near future.

WTO Membership, 2005

GATT was replaced by the World Trade Organization (WTO) in 1995. This map shows membership in the WTO in 2005.

14.5: Types of International Business

14.5.1: Countertrade

Countertrade is a system of exchange in which goods and services are used as payment rather than money.

Learning Objective

Explain the various methods of countertrading

Key Points

• Countertrade is the exchange of goods or services for other goods or services. This system can be typified as simple bartering, switch trading, counter purchase, buyback, or offset.
• Switch trading: Party A and B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
• Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
• Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
• Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Key Terms

Switch trading

Practice in which one company sells to another its obligation to make a purchase in a given country.

counter purchase

Sale of goods and services to one company in another country by a company that promises to make a future purchase of a specific product from the same company in that country.

barter

The exchange of goods or services without involving money.

Examples

• Bartering: One party gives salt in exchange for sugar from another party.
• Switch trading: Party A and Party B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
• Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
• Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
• Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Countertrade means exchanging goods or services which are paid for, in whole or part, with other goods or services, rather than with money. A monetary valuation can, however, be used in counter trade for accounting purposes. Any transaction involving exchange of goods or service for something of equal value.

Bartering

Bartering involves exchanging goods or services for other goods or services as payment.

A newspaper illustration in Harper’s Weekly where two men engaging in a barter. One man offers chickens in exchange for his yearly newspaper subscription.

There are five main variants of countertrade:

1. Barter: Exchange of goods or services directly for other goods or services without the use of money as means of purchase or payment.
2. Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.
3. Counter purchase: Sale of goods and services to one company in aother country by a company that promises to make a future purchase of a specific product from the same company in that country.
4. Buyback: This occurs when a firm builds a plant in a country, or supplies technology, equipment, training, or other services to the country, and agrees to take a certain percentage of the plant’s output as partial payment for the contract.
5. Offset: Agreement that a company will offset a hard currency purchase of an unspecified product from that nation in the future. Agreement by one nation to buy a product from another, subject to the purchase of some or all of the components and raw materials from the buyer of the finished product, or the assembly of such product in the buyer nation.

Countertrade also occurs when countries lack sufficient hard currency or when other types of market trade are impossible. In 2000, India and Iraq agreed on an “oil for wheat and rice” barter deal, subject to UN approval under Article 50 of the UN Persian Gulf War sanctions, that would facilitate 300,000 barrels of oil delivered daily to India at a price of $6.85 a barrel, while Iraq oil sales into Asia were valued at about $22 a barrel. In 2001, India agreed to swap 1.5 million tonnes of Iraqi crude under the oil-for-food program.

14.5.2: Direct Investment

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other privileges in that foreign country.

Learning Objective

Explain the effects of foreign direct investment (FDI) for the investor and the host country

Key Points

• FDI is the flow of investments from one company to production in a foreign nation, with the purpose of lowering labor costs and gaining tax incentives.
• FDI can help the economic situations of developing countries, as well as facilitate progressive internal policy reforms.
• A major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions.

Key Term

Foreign direct investment

investment directly into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Example

• Intel is headquartered in the United States, but it has made foreign direct investments in a number of Southeast Asian countries where they produce components of their products in Intel-owned factories.

Foreign direct investment (FDI) is investment into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

FDI is done for many reasons including to take advantage of cheaper wages in the country, special investment privileges, such as tax exemptions, offered by the country as an incentive to gain tariff-free access to the markets of the country or the region. FDI is in contrast to portfolio investment which is a passive investment in the securities of another country, such as stocks and bonds.

One theory for how to best help developing countries, is to increase their inward flow of FDI. However, identifying the conditions that best attract such investment flow is difficult, since foreign investment varies greatly across countries and over time. Knowing what has influenced these decisions and the resulting trends in outcomes can be helpful for governments, non-governmental organizations, businesses, and private donors looking to invest in developing countries.

Sao Paulo, Brazil

Sao Paulo, Brazil, is home to a growing middle class and significant direct investments.

Paulista Avenue in Sao Paulo, Brazil.

A study from scholars at Duke University and Princeton University published in the American Journal of Political Science, “The Politics of Foreign Direct Investment into Developing Countries: Increasing FDI through International Trade Agreements,” examines trends in FDI from 1970 to 2000 in 122 developing countries to assess what the best conditions are for attracting investment. The study found the major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions. The researchers conclude that, while “democracy can be conducive to international cooperation,” the strongest indicator for higher inward flow of FDI for developing countries was the number of trade agreements and institutions to which they were party.

14.5.3: Franchising

Franchising enables organizations a low cost and localized strategy to expanding to international markets, while offering local entrepreneurs the opportunity to run an established business.

Learning Objective

Examine the benefits of international franchising

Key Points

• A franchise agreement is defined as the franchiser granting an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products.
• Franchising is designed to enable large organizations rapid access to new markets with relatively low barriers to entry.
• Advantages of franchising (for the franchiser) include low costs of entry, a localized workforce (culturally and linguistically), and a high speed method of market entry.
• Disadvantages of franchising (for the franchiser) include loss of some organizational and brand control, as well as relatively lower returns than other strategic entry models (albeit, with lower risk).

Key Terms

franchisee

A holder of a franchise; a person who is granted a franchise.

franchiser

A franchisor, a company or person who grants franchises.

What is Franchising?

In franchising, an organization (the franchiser) has the option to grant an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products. 

In this arrangement, the franchisee will take the majority of the risk in opening a new location (e.g. capital investments) while gaining the advantage of an already established brand name and operational process. In exchange, the franchisee will pay a certain percentage of the profits of the venture back to the franchiser. The franchiser will also often provide training, advertising, and assistance with products.

Why Franchise

Lower Barriers to Entry

Franchising is a particularly useful practice when approaching international markets. For the franchiser, international expansion can be both complex and expensive, particularly when the purchase of land and building of facilities is necessary. With legal, cultural, linguistics, and logistical barriers to entry in various global markets, the franchising model offers and simpler, cleaner solution that can be implemented relatively quickly.

Localization

Franchising also allows for localization of the brand, products, and distribution systems. This localization can cater to local tastes and language through empowering locals to own, manage, and employ the business. This high level of integration into the new location can create significant advantages compared to other entry models, with much lower risk.

Speed

It is also worth noting that franchising is a very efficient, low cost and quickly implemented expansionary strategy. Franchising requires very little capital investment on behalf of the parent company, and the time and effort of building the stores are similar outsources to the franchisee. As a result, franchising can be a way to rapidly expand both domestically and globally.

Starbucks’ Expansion

Starbucks operates with a wide variety of strategic alliances, including a franchising program. 

A chart that shows how various forms of strategic alliance can rapidly increase rates of expansion.

Downsides to Franchising

Franchising has some weaknesses as well, from a strategic point of view. Most importantly, organizations (the franchisers) lose a great deal of control. Quality assurance and protection of the brand is much more difficult when ownership of the franchise is external to the organization itself. Choosing partners wisely and equipping them with the tools necessary for high levels of quality and alignment with the brand values is critical (e.g., training, equipment, quality control, adequate resources).

It is also of importance to keep the risk/return ratio in mind. While the risk of franchising is much lower in terms of capital investment, so too is the returns derived from operations (depending on the franchising agreement in place). While it is a faster and cheaper mode of entry, it ultimately results in a profit share between the franchiser and the franchisee.

14.5.4: Multinational Firms

With the advent of improved communication and technology, corporations have been able to expand into multiple countries.

Learning Objective

Explain how a multinational corporation (MNC) operates

Key Points

• Multinational corporations operate in multiple countries.
• MNCs have considerable bargaining power and may negotiate business or trade policies with success.
• A corporation may choose to locate in a special economic zone, a geographical region that has economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Key Term

Multinational corporation

A corporation or enterprise that operates in multiple countries.

Example

• McDonalds operates in over 119 different countries, making it a fairly large MNC by any standard

A multinational corporation (MNC) or multinational enterprise (MNE) is a corporation registered in more than one country or has operations in more than one country. It is a large corporation which both produces and sells goods or services in various countries . It can also be referred to as an international corporation. The first multinational corporation was the Dutch East India Company, founded March 20, 1602.

Ford 

Ford is a multinational corporation with operations throughout the world.

Corporations may make a foreign direct investment. Foreign direct investment is direct investment into one country by a company located in another country. Investors buy a company in the country or expand operations of an existing business in the country.

A corporation may choose to locate in a special economic zone, a geographical region with economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Multinational corporations are important factors in the processes of globalization. National and local governments often compete against one another to attract MNC facilities, with the expectation of increased tax revenue, employment and economic activity. To compete, political powers push toward greater autonomy for corporations. MNCs play an important role in developing economies of developing countries.

Many economists argue that in countries with comparatively low labor costs and weak environmental and social protection, multinationals actually bring about a “race to the top.” While multinationals will see a low tax burden or low labor costs as an element of comparative advantage, MNC profits are tied to operational efficiency, which includes a high degree of standardization. Thus, MNCs are likely to adapt production processes in many of their operations to conform to the standards of the most rigorous jurisdiction in which they operate.

As for labor costs, while MNCs pay workers in developing countries far below levels in countries where labor productivity is high (and accordingly, will adopt more labor-intensive production processes), they also tend to pay a premium over local labor rates of 10% to 100%.

Finally, depending on the nature of the MNC, investment in any country reflects a desire for a medium- to long-term return, as establishing a plant, training workers and so on can be costly. Therefore, once established in a jurisdiction, MNCs are potentially vulnerable to arbitrary government intervention like expropriation, sudden contract renegotiation and the arbitrary withdrawal or compulsory purchase of licenses. Thus both the negotiating power of MNCs and the “race to the bottom” critique may be overstated while understating the benefits (besides tax revenue) of MNCs becoming established in a jurisdiction.

14.5.5: Offshoring

Offshoring entails a company moving a business process from one country to another.

Learning Objective

Explain the benefits of offshoring

Key Points

• Offshoring is the relocation of certain business processes from one country to the other, resulting in large tax breaks and lower labor costs.
• Offshoring can cause controversy in a company’s domestic country since it is perceived to impact the domestic employment situation negatively.
• Offshoring of a company’s services that were previously produced domestically can be advantageous in lowering operation costs, but has incited some controversy over the economic implications.

Key Terms

offshoring

The location of a business in another country for tax purposes.

outsourcing

The transfer of a business function to an external service provider.

captive

held prisoner; not free; confined

“Offshoring” is a company’s relocation of a business process from one country to another. This typically involves an operational process, such as manufacturing, or a supporting process, such as accounting. Even state governments employ offshoring. More recently, offshoring has been associated primarily with the sourcing of technical and administrative services that support both domestic and global operations conducted outside a given home country by means of internal (captive) or external (outsourcing) delivery models.The subject of offshoring, also known as “outsourcing,” has produced considerable controversy in the United States. Offshoring for U.S. companies can result in large tax breaks and low-cost labor.

Worldwide Offshoring Business

The worldwide offshoring business is projected to equal $500 billion by 2020.

A chart that shows growth in the worldwide offshoring business.

Offshoring can be seen in the context of either production offshoring or services offshoring. After its accession to the World Trade Organization (WTO) in 2001, the People’s Republic of China emerged as a prominent destination for production offshoring. Another focus area includes the software industry as part of Global Software Development and the development of Global Information Systems. After technical progress in telecommunications improved the possibilities of trade in services, India became a leader in this domain; however, many other countries are now emerging as offshore destinations.

The economic logic is to reduce costs. People who can use some of their skills more cheaply than others have a comparative advantage. Countries often strive to trade freely items that are of the least cost to produce.

Related terms include “nearshoring,” “inshoring,” and “bestshoring,” otherwise know as “rightshoring.” Nearshoring is the relocation of business processes to (typically) lower cost foreign locations that are still within close geographical proximity (for example, shifting United States-based business processes to Canada/Latin America). Inshoring entails choosing services within a country, while bestshoring entails choosing the “best shore” based on various criteria. Business process outsourcing (BPO) refers to outsourcing arrangements when entire business functions (such as Finance & Accounting and Customer Service) are outsourced. More specific terms can be found in the field of software development; for example, Global Information System as a class of systems being developed for/by globally distributed teams.

14.5.6: Joint Ventures

In a joint venture business model, two or more parties agree to invest time, equity, and effort for the development of a new shared project.

Learning Objective

Outline the dynamics of a joint venture

Key Points

• Joint business ventures involve two parties contributing their own equity and resources to develop a new project. The enterprise, revenues, expenses and assets are shared by the involved parties.
• Since money is involved in a joint venture, it is necessary to have a strategic plan in place.
• As the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Key Term

joint venture

A cooperative partnership between two individuals or businesses in which profits and risks are shared.

Example

• Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony to develop cellular devices.

Joint Ventures

A joint venture is a business agreement in which parties agree to develop a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets.

Joint Venture

Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony.

When two or more persons come together to form a partnership for the purpose of carrying out a project, this is called a joint venture. In this scenario, both parties are equally invested in the project in terms of money, time and effort to build on the original concept. While joint ventures are generally small projects, major corporations use this method to diversify. A joint venture can ensure the success of smaller projects for those that are just starting in the business world or for established corporations. Since the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties must be committed to focusing on the future of the partnership rather than just the immediate returns. Ultimately, short term and long term successes are both important.To achieve this success, honesty, integrity and communication within the joint venture are necessary.

A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time contracts. The JV is dissolved when that goal is reached. Some major joint ventures include Dow Corning, MillerCoors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

14.5.7: Outsourcing

Outsourcing business functions to developing foreign countries has become a popular way for companies to reduce cost.

Learning Objective

Explain why companies outsource

Key Points

• Outsourcing is the contracting of business processes to external firms, usually in developing countries where labor costs are cheaper.
• This practice has increased in prevalence due to better technology and improvements in the educational standards of the countries to which jobs are outsourced.
• The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Key Terms

insourcing

The obtaining of goods or services using domestic resources or employees as opposed to foreign.

outsourcing

The transfer of a business function to an external service provider.

offshoring

The location of a business in another country for tax purposes.

Example

• Corporations may outsource their helpdesk or customer service functions to 3rd party call centers in foreign countries because these skilled laborers can do these jobs at a lesser cost than their equivalents in the domestic country.

Outsourcing

Overview

Outsourcing is the contracting out of a business process, which an organization may have previously performed internally or has a new need for, to an independent organization from which the process is purchased back as a service. Though the practice of purchasing a business function—instead of providing it internally—is a common feature of any modern economy, the term outsourcing became popular in America near the turn of the 21^st century. An outsourcing deal may also involve transfer of the employees and assets involved to the outsourcing business partner. The definition of outsourcing includes both foreign or domestic contracting , which may include offshoring, described as “a company taking a function out of their business and relocating it to another country. “

Outsourcing

Outsourcing is the process of contracting an existing business process to an independent organization. The process is purchased as a service.

Businessmen talk and shake hands.

The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Reasons for Outsourcing

Companies outsource to avoid certain types of costs. Among the reasons companies elect to outsource include avoidance of burdensome regulations, high taxes, high energy costs, and unreasonable costs that may be associated with defined benefits in labor union contracts and taxes for government mandated benefits. Perceived or actual gross margin in the short run incentivizes a company to outsource. With reduced short run costs, executive management sees the opportunity for short run profits while the income growth of the consumers base is strained. This motivates companies to outsource for lower labor costs. However, the company may or may not incur unexpected costs to train these overseas workers. Lower regulatory costs are an addition to companies saving money when outsourcing.

Import marketers may make short run profits from cheaper overseas labor and currency mainly in wealth consuming sectors at the long run expense of an economy’s wealth producing sectors straining the home county’s tax base, income growth, and increasing the debt burden. When companies offshore products and services, those jobs may leave the home country for foreign countries at the expense of the wealth producing sectors. Outsourcing may increase the risk of leakage and reduce confidentiality, as well as introduce additional privacy and security concerns.

14.5.8: Importing

Imports are the inflow of goods and services into a country’s market for consumption.

Learning Objective

Explain the methodology behind the selection of products to import

Key Points

• A country specializes in the export of goods for which it has a comparative advantage and imports those for which it has a comparative disadvantage. By doing so, the country can increase its welfare.
• Comparative advantage describes the ability of a country to produce one specific good more efficiently than other goods.
• A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically.

Key Terms

import

To bring (something) in from a foreign country, especially for sale or trade.

comparative advantage

The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.

Example

• A country in certain tropical areas of the world has a comparative advantage at growing crops like sugar or coffee beans, but it would be much less efficient at growing wheat (due to the climate). Therefore, they should export their sugar/coffee beans and import wheat at a lower cost than trying to grow wheat themselves.

The term “import” is derived from the concept of goods and services arriving into the port of a country. The buyer of such goods and services is referred to as an “importer” and is based in the country of import whereas the overseas-based seller is referred to as an “exporter.” Thus, an import is any good (e.g. a commodity) or service brought in from one country to another country in a legitimate fashion, typically for use in trade. It is a good that is brought in from another country for sale.

Singapore

The Port of Singapore is one of the busiest ports in the world. Singapore has to import most of its food and consumer goods.

A large ship at the Port of Singapore.

Imported goods or services are provided to domestic consumers by foreign producers. An import in the receiving country is an export to the sending country. Imports, along with exports, form the basics of international trade. Import of goods normally requires the involvement of customs authorities in both the country of import and the country of export; those goods are often subject to import quotas, tariffs, and trade agreements. While imports are the set of goods and services imported, “imports” also means the economic value of all goods and services that are imported.

Imports are the inflow of goods and services into a country’s market for consumption. A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically. Comparative advantage is a concept often applied to importing and exporting. Comparative advantage is the concept that a country should specialize in the production and export of those goods and services that it can produce more efficiently than other goods and services, and that it should import those goods and services in which it has a comparative disadvantage.

14.5.9: Licensing

When considering strategic entry into an international market, licensing is a low-risk and relatively fast foreign market entry tactic.

Learning Objective

Identify the benefits and risks associated with licensing as a foreign market entry model

Key Points

• Foreign market entry options include exporting, joint ventures, foreign direct investment, franchising, licensing, and various other forms of strategic alliance.
• Of these potential entry models, licensing is relatively low risk in terms of time, resources, and capital requirements.
• Advantages of licensing include localization through a foreign partner, adherence to strict international business regulations, lower costs, and the ability to move quickly.
• Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign market, and lower returns due to lower risk.
• When deciding to license abroad, careful due diligence should be done to ensure that the licensee is a strong investment for the licensor and vice versa.

Key Terms

licensee

In a licensing relationship, the buyer of the produce, service, brand or technology being licensed.

licensor

In a licensing relationship, the owner of the produce, service, brand or technology being licensed.

When considering entering international markets, there are some significant strategic and tactical decisions to be made. Exporting, joint ventures, direct investment, franchising, licensing, and various other forms of strategic alliance can be considered as market entry modes. Each entry mode has different pros and cons, addressing issues like cost, control, speed to market, legal barriers, and cultural barriers with different degrees of efficiency.

Licensing

The 1933 Fiat 508 was manufactured under a license in Poland by Polski Fiat.

What is Licensing

A licensor (i.e. the firm with the technology or brand) can provide their products, services, brand and/or technology to a licensee via an agreement. This agreement will describe the terms of the strategic alliance, allowing the licensor affordable and low risk entry to a foreign market while the licensee can gain access to the competitive advantages and unique assets of another firm. This is potentially a strong win-win arrangement for both parties, and is a relatively common practice in international business.

Let’s consider an example. The licensor is a company involved in energy health drinks. Due to food import regulations in Japan, the licensor cannot sell the product at local wholesalers or retailers. In order to circumvent this strategic barrier, the licensor finds a local sports drink manufacturer to license their recipe to. In exchange, the licensee sells the product locally under a local brand name and kicks back 15% of the overall revenues to the licensor.

The Pros and Cons

Before deciding to use licensing as an entry strategy, it’s important to understand in which situations licensing is best suited.

Advantages

Licensing affords new international entrants with a number of advantages:

• Licensing is a rapid entry strategy, allowing almost instant access to the market with the right partners lined up.
• Licensing is low risk in terms of assets and capital investment. The licensee will provide the majority of the infrastructure in most situations.
• Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry.
• Cultural and linguistic barriers are also significant challenges for international entries. Licensing provides critical resources in this regard, as the licensee has local contacts, mastery of local language, and a deep understanding of the local market.

Disadvantages

While the low-cost entry and natural localization are definite advantages, licensing also comes with some opportunity costs:

• Loss of control is a serious disadvantage in a licensing situation in regards to quality control. Particularly relevant is the licensing of a brand name, as any quality control issue on behalf of the licensee will impact the licensor’s parent brand.
• Depending on an international partner also creates inherent risks regarding the success of that firm. Just like investing in an organization in the stock market, licensing requires due diligence regarding which organization to partner with.
• Lower revenues due to relying on an external party is also a key disadvantage to this model. (Lower risk, lower returns.)

14.5.10: Contract Manufacturing

In contract manufacturing, a hiring firm makes an agreement with the contract manufacturer to produce and ship the hiring firm’s goods.

Learning Objective

Compare the benefits and risks of employing a contract manufacturer (CM)

Key Points

• A hiring firm may enter a contract with a contract manufacturer (CM) to produce components or final products on behalf of the hiring firm for some agreed-upon price.
• There are many benefits to contract manufacturing, and companies are finding many reasons why they should be outsourcing their production to other companies.
• Production outside of the company does come with many risks attached. Companies must first identify their core competencies before deciding about contract manufacture.

Key Terms

Contract manufacturing

a business model where a firm hires another firm to produce components or products

Contract manufacturing

Business model in which a firm hires a contract manufacturer to produce components or final products based on the hiring firm’s design.

A contract manufacturer (“CM”) is a manufacturer that enters into a contract with a firm to produce components or products for that firm. It is a form of outsourcing. In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labor, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm.

Contract Manufacturing

Ness Corporation is a contract manufacturer in Seven Hills, Australia.

Benefits

Contract manufacturing offers a number of benefits:

• Cost Savings: Companies save on their capital costs because they do not have to pay for a facility and the equipment needed for production. They can also save on labor costs such as wages, training, and benefits. Some companies may look to contract manufacture in low-cost countries, such as China, to benefit from the low cost of labor.
• Mutual Benefit to Contract Site: A contract between the manufacturer and the company it is producing for may last several years. The manufacturer will know that it will have a steady flow of business at least until that contract expires.
• Advanced Skills: Companies can take advantage of skills that they may not possess, but the contract manufacturer does. The contract manufacturer is likely to have relationships formed with raw material suppliers or methods of efficiency within their production.
• Quality: Contract Manufacturers are likely to have their own methods of quality control in place that help them to detect counterfeit or damaged materials early.
• Focus: Companies can focus on their core competencies better if they can hand off base production to an outside company.
• Economies of Scale: Contract Manufacturers have multiple customers that they produce for. Because they are servicing multiple customers, they can offer reduced costs in acquiring raw materials by benefiting from economies of scale. The more units there are in one shipment, the less expensive the price per unit will be.

Risks

Balanced against the above benefits of contract manufacturing are a number of risks:

• Lack of Control: When a company signs the contract allowing another company to produce their product, they lose a significant amount of control over that product. They can only suggest strategies to the contract manufacturer; they cannot force them to implement those strategies.
• Relationships: It is imperative that the company forms a good relationship with its contract manufacturer. The company must keep in mind that the manufacturer has other customers. They cannot force them to produce their product before a competitor’s. Most companies mitigate this risk by working cohesively with the manufacturer and awarding good performance with additional business.
• Quality: When entering into a contract, companies must make sure that the manufacturer’s standards are congruent with their own. They should evaluate the methods in which they test products to make sure they are of good quality. The company has to ensure the contract manufacturer has suppliers that also meet these standards.
• Intellectual Property Loss: When entering into a contract, a company is divulging their formulas or technologies. This is why it is important that a company not give out any of its core competencies to contract manufacturers. It is very easy for an employee to download such information from a computer and steal it. The recent increase in intellectual property loss has corporate and government officials struggling to improve security. Usually, it comes down to the integrity of the employees.
• Outsourcing Risks: Although outsourcing to low-cost countries has become very popular, it does bring along risks such as language barriers, cultural differences, and long lead times. This could make the management of contract manufacturers more difficult, expensive, and time-consuming.
• Capacity Constraints: If a company does not make up a large portion of the contract manufacturer’s business, they may find that they are de-prioritized over other companies during high production periods. Thus, they may not obtain the product they need when they need it.
• Loss of Flexibility and Responsiveness: Without direct control over the manufacturing facility, the company will lose some of its ability to respond to disruptions in the supply chain. It may also hurt their ability to respond to demand fluctuations, risking their customer service levels.

14.5.11: Exporting

Exporting is the practice of shipping goods from the domestic country to a foreign country.

Learning Objective

Explain how exports are accounted for in international trade

Key Points

• This term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country.
• In national accounts “exports” consist of transactions in goods and services (sales, barter, gifts or grants) from residents to non-residents.
• Statistics on international trade do not record smuggled goods or flows of illegal services. A small fraction of the smuggled goods and illegal services may nevertheless be included in official trade statistics through dummy shipments that serve to conceal the illegal nature of the activities.

Key Terms

export

to sell (goods) to a foreign country

import

To bring (something) in from a foreign country, especially for sale or trade.

exporting

the sale of capital, goods, and services across international borders or territories

exporting

the act of selling to a foreign country

Example

• When individuals from Country A purchase goods from Country B, this process is known as exporting for Country B (since their goods are being sold) and importing for Country A (since they are buying the goods).

This term “export” is derived from the concept of shipping goods and services out of the port of a country . The seller of such goods and services is referred to as an “exporter” who is based in the country of export whereas the overseas based buyer is referred to as an “importer”. In international trade, exporting refers to selling goods and services produced in the home country to other markets.

Oil Exports 2006

The map shows barrels of oil exported per day in 2006. Russia and Saudi Arabia exported more barrels than any other oil-exporting countries.

Export of commercial quantities of goods normally requires the involvement of customs authorities in both the country of export and the country of import. The advent of small trades over the internet such as through Amazon and eBay has largely bypassed the involvement of customs in many countries because of the low individual values of these trades. Nonetheless, these small exports are still subject to legal restrictions applied by the country of export. An export’s counterpart is an import.

In national accounts, exports consist of transactions in goods and services (sales, barter, gifts, or grants) from residents to non-residents.The exact definition of exports includes and excludes specific “borderline” cases. A general delimitation of exports in national accounts is as follows: An export of a good occurs when there is a change of ownership from a resident to a non-resident; this does not necessarily imply that the good in question physically crosses any border. However, in specific cases, national accounts impute changes of ownership even though in legal terms no change of ownership takes place (e.g. cross border financial leasing, cross border deliveries between affiliates of the same enterprise, goods crossing the border for significant processing to order or repair). Smuggled goods must also be included in the export measurement.

Export of services consist of all services rendered by residents to non-residents. In national accounts, any direct purchases by non-residents in the economic territory of a country are recorded as exports of services; therefore, all expenditure by foreign tourists in the economic territory of a country is considered part of the export of services of that country. International flows of illegal services must also be included.

National accountants often need to make adjustments to the basic trade data in order to comply with national accounts concepts; the concepts for basic trade statistics often differ in terms of definition and coverage from the requirements in the national accounts:

Data on international trade in goods is mostly obtained through declarations to customs services. If a country applies the general trade system, all goods entering or leaving the country are recorded. If the special trade system (e.g., extra-EU trade statistics) is applied, goods which are received into customs warehouses are not recorded in external trade statistics unless they subsequently go into free circulation in the country of receipt.

14.6: The Global Corporation

14.6.1: Definition and Challenges of a Global Corporation

Global corporations operate in two or more countries and face many challenges in their quest to capture value in the global market.

Learning Objective

Identify the most meaningful challenges encountered by multinational corporations (MNCs) when pursuing global markets and efficiencies

Key Points

• A multinational corporation (MNC) is present in several countries, which improves the company’s ability to maintain market share and earn higher profits.
• As GDP growth migrates from mature economies, such as the US and EU member states, to developing economies, such as China and India, it becomes highly relevant to capture growth in higher growth markets.
• Despite the general opportunities a global market provides, there are significant challenges in penetrating these markets. These consist of public relations, ethics, corporate structure, and leadership.
• Combining these challenges with the inherent opportunities a global economy presents, companies are encouraged to pursue high value opportunities while carefully controlling the risks involved.

Key Terms

economies of scope

Lowering average cost for a firm in producing two or more products through the common and recurrent use of proprietary know-how or an indivisible physical asset.

economies of scale

The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.

value-chain

The series of operations necessary for a business to operate.

Global Corporations

A global company is generally referred to as a multinational corporation (MNC). An MNC is a company that operates in two or more countries, leveraging the global environment to approach varying markets in attaining revenue generation. These international operations are pursued as a result of the strategic potential provided by technological developments, making new markets a more convenient and profitable pursuit both in sourcing production and pursuing growth.

International operations are therefore a direct result of either achieving higher levels of revenue or a lower cost structure within the operations or value-chain. MNC operations often attain economies of scale, through mass producing in external markets at substantially cheaper costs, or economies of scope, through horizontal expansion into new geographic markets. If successful, these both result in positive effects on the income statement (either larger revenues or stronger margins), but contain the innate risk in developing these new opportunities.

Opportunities

As gross domestic product (GDP) growth migrates from mature economies, such as the US and EU member states, to developing economies, such as China and India, it becomes highly relevant to capture growth in higher growth markets. is a particularly strong visual representation of the advantages a global corporation stands to capture, where the darker green areas reppresent where the highest GDP growth potential resides. High growth in the external environment is a strong opportunity for most incumbents in the market.

GDP Growth Rate by Country

This map highlights where the strongest growth opportunities currently are, as of 2010. In that year China and India had the highest GDP growth rates.

Challenges

However, despite the general opportunities a global market provides, there are significant challenges MNCs face in penetrating these markets. These challenges can loosely be defined through four factors:

• Public Relations: Public image and branding are critical components of most businesses. Building this public relations potential in a new geographic region is an enormous challenge, both in effectively localizing the message and in the capital expenditures necessary to create momentum.
• Ethics: Arguably the most substantial of the challenges faced by MNCs, ethics have historically played a dramatic role in the success or failure of global players. For example, Nike had its brand image hugely damaged through utilizing ‘sweat shops’ and low wage workers in developing countries. Maintaining the highest ethical standards while operating in developing countries is an important consideration for all MNCs.
• Organizational Structure: Another significant hurdle is the ability to efficiently and effectively incorporate new regions within the value chain and corporate structure. International expansion requires enormous capital investments in many cases, along with the development of a specific strategic business unit (SBU) in order to manage these accounts and operations. Finding a way to capture value despite this fixed organizational investment is an important initiative for global corporations.
• Leadership: The final factor worth noting is attaining effective leaders with the appropriate knowledge base to approach a given geographic market. There are differences in strategies and approaches in every geographic location worldwide, and attracting talented managers with high intercultural competence is a critical step in developing an efficient global strategy.

Combining these four challenges for global corporations with the inherent opportunities presented by a global economy, companies are encouraged to chase the opportunities while carefully controlling the risks to capture the optimal amount of value. Through effectively maintaining ethics and a strong public image, companies should create strategic business units with strong international leadership in order to capture value in a constantly expanding global market.

14.7: Managing International Corporations

14.7.1: Considerations when Managing a Global Corporation

Strong global management skills, intercultural competence, and a sensitivity to cultural issues are necessities for global managers.

Learning Objective

Recognize the considerations global managers are faced with as they integrate into a broader and more globalized business environment

Key Points

• As multinational corporations grow in both size and quantity, the inherent managerial implications of a fully globalized economy demonstrate higher levels of relevance and importance within global corporations.
• Global management skills are largely based in developing cultural intelligence, or a high cultural quotient (CQ), which delineates an individual’s general understanding and adaptability of foreign cultures.
• Once managers attain the appropriate levels of cultural intelligence, it becomes necessary to apply this to the corporate framework.
• Geographic and demographic expansions underline the critical importance of managers to understanding the illusive concept of localization.
• It is also critical in cross-cultural endeavors to maintain one’s own sense of values and ethics.
• To summarize these concepts, managers of global corporations are faced with substantial opportunities for growth alongside significant threats in cultural differences.

Key Terms

localization

Act or process of making a product suitable for use in a particular country or region.

globality

The end result of globalization, an economy entirely without geographic borders.

cross-cultural knowledge

Expertise in varying cultures across the globe.

Considerations of Global Managers

As multinational corporations grow in both size and quantity, the inherent managerial implications of a fully globalized economy demonstrate higher levels of relevance and importance within global corporations. The development of global management skills, as well as the intercultural competence to identify and develop sensitivity to cultural issues, becomes a larger factor in the overall success of these business models. Through identifying the necessary global skill set and effectively implementing these global managers within the business structure, multinational corporations can attain competitive advantage through cross-cultural knowledge.

Cultural Intelligence

Global management skills are largely based in developing cultural intelligence, or a high cultural quotient (CQ), which delineates an individual’s general understanding and adaptability of foreign cultures. This is best achieved through understanding what constitutes a high level of intercultural competence and leveraging this confidence to achieve the desire results in global management (see Boundless’s “Cultural Intelligence” section). To summarize the concept of intercultural competence, the basics necessary for effectively developing this is a linguistic understanding, a cultural understanding (religion, ethics, values, etc.), and regional expertise (ethnicity/geography).

Localization

Once managers attain the appropriate levels of cultural intelligence, it becomes necessary to apply this to the corporate framework. Global management requires a high level of corporate strategy to effectively implement, as not only is the workforce developing in diversity but so is the customer base. Geographic and demographic expansions underline the critical importance of managers to understanding the illusive concept of localization, which in short defines the way in which a company’s product or service should be adapted to fill the specific needs of a particular culture, demography, or geographic region. Researching the failure of companies, such as Best Buy and Home Depot in China, and bench-marking this against the success of Pizza Hut or BMW, provides substantial insights as to the importance of localization to global managers.

What localization truly highlights is the need to hold a highly developed sensitivity to cultural issues, norms, and values. It is also critical in cross-cultural endeavors to maintain one’s own sense of values and ethics, particularly as differences in standards of living, GDP per capita, economic growth rates, and political environments come into play. The figure (see ) highlights the remarkable growth rates in developing economies such as China, but fails to note the human rights and legal complications for multinationals in approaching these markets in an ethical manner. With lower standards of livings in certain regions, as well as differences in capitalistic philosophies and legalities, sensitivity to cultural differences is absolutely crucial in sidestepping the pitfalls of merging cultures that contradict one another.

Change in GDP

This graph shows growth in gross domestic product in various advanced economies, accumulated over the periods 1990–1999 and 1990-2006. China shows the most notable change in GDP, from 125% growth over 1990–1999 to 325% growth over 1990–2006. India, Ireland, Korea, and Singapore show substantial respective increases from around 50% growth to around 150% growth.

To summarize these concepts, managers of global corporations are faced with substantial opportunities for growth alongside significant threats in cultural differences. Sensitivity to important cultural considerations and the development of a highly perceptive intercultural competency is a prerequisite for any global corporations considering geographic expansion into a new market. With theories, such as globality underlining the trajectory of global inter-dependency, this opportunity is a necessary consideration to any multinational corporation hoping to remain a competitor in a fully globalized economy.

Example

Researching the failure of companies, such as Best Buy and Home Depot in China, and bench-marking this against the success of Pizza Hut or BMW, provides substantial insights as to the importance of localization to global managers.

13.4: Corporate Social Responsibility

13.4.1: Introduction to Corporate Social Responsibility

Learning Objective

Explain the purpose and types of corporate social responsibility

Key Points

• Corporate social responsibility (CSR) can be described as embracing responsibility and encouraging a positive impact through the company’s activities related to the environment, consumers, employees, communities, and other stakeholders.
• Corporate social responsibility may include philanthropic efforts, employee volunteering, and core strategies. Companies may benchmark their CSR performance relative to peers and may also report on CSR policies or undergo social audits.
• Proponents of CSR argue that socially responsible practices can have a positive impact on the bottom line and may also argue for the recognition of a “triple bottom line” that rewards social, environmental, and financial returns.
• Critics argue that CSR competes with shareholder value maximization and may be prone to “greenwashing”.

Key Terms

benchmark

A standard by which something is evaluated or measured.

shareholder

One who owns shares of stock in a business.

stakeholder

A person or organization with a legitimate interest in a given situation, action, or enterprise.

Corporate Social Responsibility (CSR), also referred to as corporate citizenship or socially responsible business, is a form of corporate self-regulation integrated into a business model. The interest in CSR has grown with the spread of socially responsible investing, the attention of nongovernmental organizations (NGOs), and ethics training within organizations. Recent incidents of ethics-based corporate scandals have also increased awareness of CSR. Organizations that embrace CSR hold themselves accountable to others for their actions and seek to make a positive impact on the environment, their communities, and the larger society.

Corporate social responsibility may include philanthropic efforts such as charitable donations or programs that encourage employee volunteerism by providing paid time off for such activities. Many organizations seek to have an even greater impact through CSR initiatives that integrate social values into operational and business strategies. For example, to protect scarce natural resources, a firm may make a commitment to use only recycled materials in its packaging of consumer goods.

Many organizations promote their CSR efforts as a way of shaping public perceptions, attracting customers, and building good will with stakeholders. Public companies often report CSR policies and activities in their annual reports; some create separate documents or use their websites to describe and publicize their CSR-related efforts. Organizations and interested external third parties assess CSR performance by comparing, or benchmarking, the activities and their results with competitors or other sets of organizations. Measures include amount of expenditures or investment, degree of executive engagement, impact of implementation, and CSR outcomes relative to objectives.

Green building

This company building in the UK was created from green materials.

The scale and nature of the benefits of CSR to an organization can be difficult to quantify. Those driven by strategic and operational choices may result in higher or lower costs, but directly linking CSR initiatives to revenue increases is not always possible. Many organization use non-financial measures to assess the benefits of CSR. For example, socially responsible practices can improve employee recruitment and retention efforts, be a means of managing risk, and provide brand differentiation. Some business critics of CSR, however, argue that too often it competes with a duty to maximize shareholder value. Others cast the CSR efforts of companies as “greenwashing” efforts to draw attention away from unpopular practices such as polluting the environment or outsourcing jobs overseas.

13.4.2: Arguments for and against Corporate Social Responsibility

Learning Objective

Contrast the views in favor of and opposing corporate social responsibility

Key Points

• Proponents of corporate social responsibility (CSR) argue that socially responsible practices can have a positive impact on the bottom line.
• While some evidence links CSR to financial performance, its proponents also point to non-financial rewards as well as to benefits to the environment and social welfare.
• Some critics see CSR as unrelated to the primary aim of the business: making a profit for its shareholders.
• Critics may also see some CSR efforts as attempts at public manipulation or greenwashing.

Key Terms

shareholder

One who owns shares of stock in a business.

bottom line

The final balance; the amount of money or profit left after everything has been tallied.

Corporate social responsibility, also referred to as CSR, can be described as embracing responsibility for a company’s actions and encouraging a positive impact through its activities on the environment, consumers, employees, communities, and other stakeholders.

Corporate social responsibility (CSR)

CSR refers to the practice of companies integrating ethical, social, environmental, and other global issues into their business operations and in their interaction with their stakeholders (employees, customers, shareholders, investors, local communities, government).

While some evidence links CSR practices to business performance, most organizations point to the non-financial benefits of their efforts. Proponents of CSR argue that socially responsible practices can have a positive impact on the organization by improving employee recruitment and retention, managing environmental risks by reducing harmful accidents, and differentiating brand to achieve greater consumer loyalty. CSR proponents may also argue for the recognition of a “triple bottom line” performance that includes not only financial returns for owners but also social and environmental benefits for the greater society.

Milton Friedman and other conservative critics have argued against CSR, stating that a corporation’s purpose is to maximize returns to its shareholders (or shareholder value) and that it does not have responsibilities to society as a whole. Part of the critics’ argument is that managers should not select social causes on behalf of a diverse set of owners. Rather, CSR opponents believe that corporations benefit society best by distributing profits to owners, who can then make charitable donations or take other socially responsible actions as they see fit.

Other critics, rather than targeting the concept of CSR, point to examples of weak CSR programs. For example, the term greenwashing refers to instances where businesses have spent significantly more resources advertising being “green“ (that is, operating with consideration for the environment) than investing in the environmentally sound practices themselves. Critics view these as misleading, even cynical, attempts to shape public perception about a company without its actually having to benefit the environment.

13.4.3: Social Responsibility Audits

Learning Objective

Apply the general concept of auditing to the larger framework of social responsibility within organizations

Key Points

• Social responsibility audits rely on a process of accounting known by various names, including social accounting, sustainability accounting, corporate social responsibility (CSR) reporting, environmental and social governance (ESG) reporting, and triple-bottom-line accounting.
• Most social, environmental, and sustainability reports are produced voluntarily by corporations themselves and are not held to the same external standards as financial reporting. The practice of hiring independent social responsibility audit firms, however, is growing.
• Little consensus exists about how to define and use metrics of social performance, making social audits different from financial audits, for which there are generally accepted standards.

Key Terms

responsibility

A duty, obligation, or liability for which someone is held accountable.

audit

An independent review of records and activities to assess system controls, to ensure compliance with established policies and procedures, and to recommend changes in controls, policies, or procedures.

An audit is a systematic independent examination of data, statements, records, operations, and performance (financial or otherwise) of a process or enterprise for a stated purpose. The purpose of an audit is to provide third-party assurance to various stakeholders that the subject matter is free from material misstatement and represents a true and accurate depiction of actions and events. Areas of business that are commonly audited include financial performance, internal controls, quality management, project management, water management, and energy conservation.

Social responsibility audits are a process of reviewing and evaluating a corporation’s social responsibility (CSR) performance. As with financial audits, social responsibility audits involve accounting processes. This type of accounting originated in the early 1990s and is known by various names, including social accounting, sustainability accounting, CSR reporting, environmental and social governance (ESG) reporting, and triple-bottom-line accounting (encompassing social and environmental as well as financial reporting). Social accounting is the process of communicating the social and environmental effects of an organization’s economic actions to particular interest groups within society—including investors, customers, and NGOs—as well as to society at large.

In most countries, existing legislation regulates only a fraction of accounting for socially relevant corporate activity. In consequence, most social, environmental, and sustainability reports are produced voluntarily by corporations themselves and are not held to the same legal standards as financial reporting, for example. Organizations may also hire external firms to conduct CSR audits; these often have more credibility than an internally generated report. Having third-party groups conduct social audits is one way that corporations are held accountable for their CSR performance.

Little consensus exists about the definition and use of metrics to evaluate social impact. The lack of clearly defined standards makes social audits different from financial audits, for which there are generally accepted standards. Environmental-related accounting might address pollution emissions, resources used, or wildlife habitats damaged or re-established. Social aspects considered might include worker conditions or community investment. An audit for economic and governance responsibilities might look at transparency and the use of practices such as independent board members and separation of the roles of CEO and board chairman.

Factory workers in 1920s

One metric that might be tested in a social responsibility audit is worker conditions in the company’s plants.

13.4.4: Types of Social Responsibility: Sustainability

Key Points

• Sustainability generally refers to a company’s capacity to endure over the long term through renewal, maintenance, and sustenance. From an organizational perspective, it includes stewardship for sustaining not just the organization but also its various stakeholders.
• While a universally accepted definition of sustainability remains elusive, according to a common definition, sustainability has three key dimensions: environmental, social, and economic.
• Tracking sustainability measures can be performed through sustainability accounting, in which a corporation discloses its performance with respect to activities directly affect the social, environmental, and economic performance of an organization.
• Environmental aspects can relate to water, land, and atmospheric impact, including energy and chemical use. Social sustainability can include human and worker rights and community issues. Economic aspects can include financial transparency and accountability and corporate governance.

Key Terms

impact

A significant or strong influence; an effect.

stewardship

The act of caring for or improving with time.

Many efforts to show corporate social responsibility, or CSR, focus on environmental, social, and economic sustainability. Sustainability is the capacity to endure over the long term through renewal, maintenance, and sustenance. From an organizational perspective, sustainability is a criteria used to make decisions about business conduct and to evaluate outcomes.

Environmental sustainability involves efforts to protect air, water, and land from any harmful effects. It also encompasses stewardship for natural resources, such as trees and wildlife. Sustainable business practices consider not only the use of resources in production, but also the assurance that those resources can be replenished for future use. Energy is another area of interest in environmental sustainability. Reducing greenhouse gasses harmful to the atmosphere and embracing alternative, renewable fuel sources such as wind and energy are examples of business practices in this area.

The social dimension of sustainability addresses concerns such as peace and social justice. Efforts to improve education, to expand worker rights, to minimize the use of child labor, and to increase the political empowerment of women, especially in developing countries, are examples of social sustainability practices. Reducing poverty by helping people develop the skills to earn their own livelihoods is another example of social sustainability. Projects that provide access to clean water and sanitation are also aimed at improving social sustainability by reducing illness and mortality rates.

Economic sustainability refers to business practices that do not diminish the prospects of future persons to enjoy levels of consumption, wealth, utility, or welfare comparable to those enjoyed in the present. This means companies’ operational practices reduce environmental damage and resource depletion. Efforts to influence business practices toward economic sustainability include pricing mechanisms, such as carbon taxes, that pass on the cost of environmental impact to the users of those resources.

Tracking sustainability measures can be performed using sustainability accounting, in which a corporation discloses its performance with respect to activities that have a direct impact on the societal, environmental, and economic performance of an organization. According to common definitions, sustainability has three key dimensions: environmental, social, and economic. The three pillars—also known as the “triple bottom line”—have served as a common ground for numerous sustainability standards and certification systems in recent years, though a universally accepted definition of sustainability remains elusive.

Triple bottom line

Sustainable design of a business can be an aspect of corporate social responsibility.

13.4.5: Types of Social Responsibility: Philanthropy

Learning Objective

Describe philanthropy through the lens of corporate social responsibility

Key Points

• Philanthropic corporate social responsibility involves donating funds, goods, or services to another organization or cause. For example, the local branch of a bank might donate money to fund the purchase of uniforms for a school sports team, or a health care company might donate to the city opera.
• Some critique organizational philanthropy for not being incorporated directly into an organization’s core business plan. Philanthropic activity is not always tracked as part of social accounting, making it difficult for these efforts to be audited or held accountable to external benchmarks.
• Corporations increasingly hold charities accountable for the use of donations and for measuring performance relative to their mission.

Key Terms

core

The most important part of a thing; the essence.

impact

A significant or strong influence; an effect.

A company that practices corporate social responsibility (CSR) embraces responsibility for its actions and, through its activities, positively affects the environment, society, consumers, employees, communities, and other stakeholders. One type of CSR is philanthropic giving. The roots of corporate philanthropy in the United States date back to the rise of industry in the 19th and early 20th century, when pioneering businessmen like Henry Ford and John D. Rockefeller established a number of philanthropic foundations. Today, corporate philanthropy can involve donating funds, goods, or services to another organization or cause. For example, the local branch of a bank might donate money to fund the purchase of uniforms for a school sports team, or a health care company might donate to the city opera.

Corporate social responsibility

CSR pertains to the positive effects a company’s operations have on the environment, consumers, and society at large.

While individual philanthropists use their own resources to change the world for the better according to their interests, corporate philanthropy directs organizational resources to support a worthy cause or address a societal need. The practice is not without its critics; some complain that philanthropic CSR is not directly related to an organization’s core business. For instance, many large arts organizations receive funding from corporations in completely different industries simply because their executives happen to love music and wish to support a local symphony. Although philanthropic CSR may provide public relations or branding advantages to a business, these benefits are difficult to measure and track.

A business’s philanthropic activity does not occur without oversight. Since the early 2000’s, corporations have sought to hold charities accountable for how they use donations. As a result, many nonprofit groups have adopted business practices for measuring their own performance. In this way, these beneficiaries of philanthropy demonstrate both a responsible use of the funds they have received and evidence of their performance relative to their mission. Companies engaging in philanthropic CSR can then use those results to measure the impact of their own efforts to support social causes.

13.4.6: Types of Social Responsibility: Ecocentric Management

Learning Objective

Explain the concept of ecocentric corporate social responsibility and how it relates to other forms of CSR

Key Points

• Ecocentric CSR seeks to protect and improve the quality of the natural environment, regardless of the economic benefits to an organization.
• Ecocentric CSR reflects an organization’s commitment to the environment as the primary core value for conducting business.
• As a core business activity, ecocentric management may also incorporate life-cycle assessment, a technique aimed at assessing the environmental impacts associated with all stages of a product’s life, from raw material extraction to disposal or recycling.

Key Term

ecology

The branch of biology dealing with the relationships of organisms with their environment and with each other.

Corporate social responsibility, also referred to as CSR, can be described as a business’s efforts to assume responsibility for its actions and to encourage a positive impact through its activities on the environment, consumers, employees, communities, and other stakeholders. Ecocentric management is one type of CSR that adopts a deeply ecological view of business.

The ecocentric model differs from more human-centered interpretations of sustainability or responsibility. “Deep” ecology is a form of environmentalism that seeks to protect and improve the quality of the natural environment. It values environmental good above economic or even social benefits. For this reason, ecocentric CSR activities, more than any other type of CSR efforts, are not expected to provide business benefits. Instead, they reflect an organization’s commitment to the environment as the primary core value for conducting business.

Ecocentric supporters believe that low-impact technology and self-reliance are more desirable than technological control over nature. As a result, the ecocentric manager may argue against using ecologically damaging products, such as pesticides and nuclear power, even if these products benefit people. In this way, the ecocentric approach contrasts with that of a more traditional CSR environmental sustainability, which seeks to maintain economic performance while reducing the impact of those products or making parallel investments in alternatives.

Emerging Values: Environmentalism and Green Energy

Image of an energy plant.

Ecocentric CSR activities are typically integrated with business operations. For example, they may incorporate life-cycle assessment, a technique aimed at assessing the environmental impacts associated with all the stages of a product’s life, from raw material extraction through materials processing, manufacture, distribution, use, repair and maintenance, and disposal or recycling. The more environmentally harmful stages can be identified and targeted for improvement so that every part of the value chain demonstrates the paramount importance of ecocentric CSR.

13.4.7: The Financial Value of Social Responsibility

Learning Objective

Discuss the argument that the short-term costs of social responsibility generate long-term revenues exceeding those costs

Key Points

• Evidence links socially responsible business practices to improved financial performance.
• Socially focused investors also see a financial return in socially responsible business practices, pointing to competitive returns for socially responsible indices and to the belief in returns from investing in a company’s long-term potential to compete and succeed.
• The shared value model takes a long-term view on financial return of corporate social responsibility (CSR), maintaining that the competitiveness of a company and the health of the communities around it are mutually dependent.

Key Terms

externalities

Something that indirectly affects something else. In economics, a cost or benefit that is not captured in the price mechanism.

triple bottom line

A means of measuring a company’s success based on its economic returns, its effect on its environment, and its impact on the community.

shared value model

Idea that corporate success and social welfare relate; that a company succeeds and competes in a better society because it needs a healthy, educated workforce and sustainable resources.

Evidence links socially responsible business practices to improved financial performance. This is attributable to lower costs or increased revenue from customers who want to support business that reflects their personal values. An organization’s CSR practices might also increase employee loyalty, which lowers the cost of turnover; it also helps attract potential employees willing to work for less for a company whose values they share. Some CSR actions, such as investing in renewable energy, can provide tax benefits or lead to technology innovations that create competitive advantage.

Harvard professors Michael Porter and Mark Kramer introduced the notion of “creating shared value” (CSV) as a way of thinking about the benefits of corporate social responsibility. CSV is based on an idea that the competitiveness of a company and the health of the communities around it are mutually dependent. By focusing on creating shared value, an organization helps to shape the context in which it competes to its advantage. In this way, the shared value model takes a long-term perspective on the financial benefits of corporate social responsibility.

Other financial benefits from CSR accrue directly to shareholders. Socially conscious investors may prefer to own shares of a company that demonstrates good CSR, which can lead to higher share prices. Some mutual funds have portfolios exclusively made up of companies that rate highly on independent CSR measures. Proponents of these funds point to competitive returns for socially responsible indices, such as the Domini 400 (now the MSCI KLD 400). Similarly, academic studies have shown that excluding stocks from companies with poor CSR records does not adversely effect financial returns of a fund.

Corporate social responsibility

The benefits a company obtains from having a strong community and healthy environment may not generally be expressed in dollars, but these elements do have a financial impact on a business.

12.4: Creating Strategy: Common Approaches

12.4.1: Strategic Management

Learning Objective

Identify the five general steps that allow businesses to develop a strategic process

Key Points

• Strategic management analyzes the major initiatives, involving resources and performance in external environments, that a company’s top management takes on behalf of owners.
• The first three steps in the strategic management process are part of the strategy formulation phase. These include analysis, strategy formulation, and goal setting.
• The final two steps in strategic management constitute implementation. These steps include creating the structure (internal environment) and obtaining feedback from the process.
• By integrating these steps into the strategic management process, upper management can ensure resource allocation and processes align with broader organizational purpose and values.

Key Terms

implementation

The process of moving an idea from concept to reality. In business, engineering, and other fields, implementation refers to the building process rather than the design process.

objectives

The goals of an organization.

Strategic management analyzes the major initiatives, involving resources and performance in external environments, that a company’s top management takes on behalf of owners. It entails specifying the organization’s mission, vision, and objectives, as well as developing policies and plans which allocate resources to drive growth and profitability. Strategy, in short, is the overarching methodology behind the business operations.

Strategic management framework

The above model is a summary of what is involved in each of the five steps of management: 1. analysis (internal and external), 2. strategy formation (diagnosis and decision-making), 3. goal setting (objectives and measurement), 4. structure (leadership and initiatives), and 5. control and feedback (budgets and incentives).

Five Steps of Strategic Management

As strategic management is a large, complex, and ever-evolving endeavor, it is useful to divide it into a series of concrete steps to illustrate the process of strategic management. While many management models pertaining to strategy derivation are in use, most general frameworks include five steps embedded in two general stages:

Formulation

1. Analysis – Strategic analysis is a time-consuming process, involving comprehensive market research on the external and competitive environments as well as extensive internal assessments. The process involves conducting Porter’s Five Forces, SWOT, PESTEL, and value chain analyses and gathering experts in each industry relating to the strategy.
2. Strategy Formation – Following the analysis phase, the organization selects a generic strategy (for example, low-cost, differentiation, etc.) based upon the value-chain implications for core competence and potential competitive advantage. Risk assessments and contingency plans are also developed based upon external forecasting. Brand positioning and image should be solidified.
3. Goal Setting – With the defined strategy in mind, management identifies and communicates goals and objectives that correlate to the predicted outcomes, strengths, and opportunities. These objectives include quantitative ways to measure the success or failure of the goals, along with corresponding organizational policy. Goal setting is the final phase before implementation begins.

Implementation

1. Structure – The implementation phase begins with the strategy in place, and the business solidifies its organizational structure and leadership (making changes if necessary). Leaders allocate resources to specific projects and enact any necessary strategic partnerships.
2. Feedback – During the final stage of strategy, all budgetary figures are submitted for evaluation. Financial ratios should be calculated and performance reviews delivered to relevant personnel and departments. This information will be used to restart the planning process, or reinforce the success of the previous strategy.

12.4.2: Combining Internal and External Analyses

Learning Objective

Apply a comprehensive understanding of internal and external analyses to the effective formation of new strategic initiatives

Key Points

• Organizations must carefully consider what internal assets are available that will differentiate them from the competition, within the same competitive environment.
• Similarly, organizations must understand the context in which they operate if they aspire to acquire competitive advantage over other incumbents.
• By understanding how internal and external factors relate, companies can piece together the ideal way in which their strengths can capture opportunities while offsetting threats and rectifying weaknesses.
• Implementing strategies that take into account both the internal and external environments will likely achieve competitive advantage and improve an organization’s ability to adapt. This is profit-generating strategic thinking.

Key Terms

external

Concerned with the public affairs of a company or other organization.

internal

Concerned with the non-public affairs of a company or other organization.

Organizations must carefully consider what internal assets will differentiate them from the competition, within the same competitive environment. This internal analysis requires careful consideration of the following models and factors:

• Core mission
• Overall strategy
• Porter’s competitive strategies
• SWOT analysis
• Forecasts
• Resource-based view

SWOT Analysis

Here is an example of the SWOT analysis matrix, which arranges strengths, weaknesses, opportunities, and threats.

Similarly, organizations must understand the context in which they operate if they aspire to acquire competitive advantage over other incumbents. Models such as the following outline these concerns effectively:

• Porter’s five forces (and limitations)
• PESTEL and SCP
• Competitive dynamics

Merging Analyses for Competitive Advantage

These inputs generally outline each of the specific analyses a company should conduct to understand its internal and external environments. Combining these two constitutes context analysis, which is a method of analyzing the environment in which a business operates. Environmental scanning focuses mainly on the macro-environment of a business. Context analysis considers the entire environment of a business, both internal and external.

Using context analysis, alongside the necessary external and internal inputs, companies are able to generate strategies which actively capitalize on this knowledge in pursuit of competitive advantage. This strategic development requires companies to understand the opportunities and threats in the external environment and benchmark these against the strengths and weaknesses of their internal environment. By understanding how internal and external factors relate, companies can piece together the ideal way in which their strengths can capture opportunities while offsetting threats and rectifying weaknesses.

This melding of internal and external factors in pursuit of competitive advantage is an ongoing process, as the company must evolve and change in concert with the environment. As a result, strategic management is the process of constantly assessing both environments to ensure that the company retains a unique competitive position in which to generate value for stakeholders and customers. This implementation of strategies that take into account both the internal and external environments eventually achieves dynamic capabilities for the companies involved.

Change is costly, so firms must develop processes to find low pay-off changes. The ability to change depends on the ability to scan the environment, evaluate markets, and quickly accomplish reconfiguration and transformation ahead of the competition. These actions can be supported by decentralized structures, local autonomy, and strategic alliances.

12.4.3: Implementing Strategy

Learning Objective

Define the necessary processes involved in executing and implementing a newly created strategy

Key Points

• The implementation process requires establishing or modifying the organizational hierarchy, allocation of resources, accountability, and control processes.
• Depending on industry and geographic location, implementation often requires integrating an organization with other firms via strategic partnerships (suppliers, joint ventures, acquisitions, etc.).
• To implement a strategy requires moving beyond the theoretical and research-based view. This demands practical pragmatism on the part of senior strategists.
• Action plans that describe the way processes are transformed into tangible operations are a critical success factor and often a point of difficulty for conceptual strategists.

Key Terms

hierarchy

An arrangement of items in which the items are represented as being “above,” “below,” or “at the same level as” one another.

implementation

The process of moving an idea from concept to reality. In business, engineering, and other fields, implementation refers to the building process rather than the design process.

execute

To carry out; to put into effect.

The implementation process requires establishing or modifying an organizational hierarchy so the company can achieve its objectives. The following stages constitute the strategic implementation process:

• Allocating and managing sufficient resources (financial, personnel, operational support, time, technology support)
• Establishing a chain of command or some alternative structure (such as cross-functional teams)
• Assigning responsibility of specific tasks or processes to specific individuals or groups. Accountability is critical to the action plan process.
• Creating a feedback loop for control processes

Strategy implementation also involves managing the overall process. Process management comprises monitoring results, measuring benchmarks, following best practices, evaluating the efficacy and efficiency of the process, controlling for variances, and making adjustments to the process as necessary. When an organization implements specific programs, it must acquire the requisite resources, develop the process, train, and perform process testing, documentation, and integration with legacy processes.

A visual depiction of the strategic management process

The strategic management process never ends. The process restarts after a plan ends, when the company reviews the results and re-evaluates its position.

Additionally, businesses must consider the exact means of implementing a strategy, which may entail:

• Alliances with other firms to fill capability/technology/resource/legal gaps
• Investment in internal development
• Mergers/acquisitions of products or firms to reduce time to market
• Doing business with protectionist countries such as India and China, which require market entrants to operate via partnerships with local firms

Executing a Strategic Plan

One of the core goals when drafting a strategic plan is to develop it in a way that is easily translated into action plans. Most strategic plans address high-level initiatives and overarching goals but are not always translated into the day-to-day projects and tasks required to achieve the plan.

Poor terminology or word choice and the wrong level of writing are both examples of ways to fail to translate a strategic plan so that it makes sense and is executable. Often, plans are filled with conceptual terms that do not connect to day-to-day realities for the staff that is expected to carry out the plans. Strategists need to be both practical and pragmatic when devising strategy for effective implementation.

Put simply, walking the talk is easy to say and difficult to accomplish. Strategy formulation must always consider the implementation phase as the primary framework. Action plans that describe the way processes are transformed into tangible operations are a critical success factor and often a point of difficulty for conceptual strategists.

12.4.4: Maintaining Control

Learning Objective

Apply the concept of maintaining control to planning and strategy

Key Points

• Dissonance is often present between the way in which the company ideally wants to operate from a strategic perspective and the way it actually does.
• Planning and controlling are closely linked. Planning is the benchmark which controlling uses to outline deviations. In this sense, they are two sides of the same strategic process of improvement.
• Once a company designs a strategic plan parallel with the corporate mission and vision, the implementation process requires both control and planning to ensure it is appropriately communicated and executed.
• Managers are tasked with ensuring that the organizational processes reflect the mission statement and vision as closely as possible, controlling aspects of the operations in pursuit of this goal.

Key Terms

controlling

To exercise influence over, to suggest or dictate the behavior of.

planning

The act of formulating a course of action, or of drawing up plans.

Controlling is one of the primary theoretical managerial functions (alongside planning, organizing, staffing, and directing). Maintaining control is about identifying deviations from intended results and improving the process to achieve desired outcomes. According to modern concepts, control is a foreseeing action; an earlier concept of control identified it as chiefly detecting errors.

Control in management means setting standards, measuring actual performance, and taking corrective action. Control thus comprises three main questions: Where are we now? Where did we plan to be? How can we bridge the gap between the two? Control is inherently cyclical.

Monitoring and controlling project activities

These steps are involved in management control of project activities.

Robert J. Mockler on Control

Robert J. Mockler presented a more comprehensive definition of managerial control. He defined it as a systematic effort by business management to compare performance to predetermined standards, plans, or objectives to assess whether performance is in line with these standards and presumably to take any remedial action required. According to Mockler, the purpose of control is to ensure that human and other corporate resources are being used in the most effective and efficient way possible in achieving corporate objectives.

Relationship Between Planning and Controlling

Mockler’s definition shows the close link between planning and controlling. Planning is a process which establishes an organization’s objectives and the methods to achieve those objectives. Controlling is a process that measures and directs the actual performance against the planned goals of the organization. Thus, goals and objectives are often referred to as Siamese twins of management: managing and correcting performance to make sure that enterprise objectives and the goals designed to attain them are accomplished.

Application to Strategy

Control, relative to strategy, defines the latter stage of overall strategy. Once a company designs a strategic overview parallel with the corporate mission and vision, the implementation process requires control to ensure that strategy is appropriately communicated and executed. The direction of organizational control derives from the strategic plan of the organization. Control is an active process that evaluates current performance against this strategic backdrop to ascertain how closely the operations represent the desired functioning of the company.

Dissonance is often present between the way in which the company ideally wants to operate from a strategic perspective and the way it actually does. This is where control comes into play. Managers are tasked with ensuring that the organizational processes reflect the mission statement and vision as closely as possible, controlling aspects of the operations in pursuit of this goal. As a result, maintaining control is a constant responsibility that keeps the business as close as possible to its core strategies.

12.5: Common Types of Corporate Strategies

12.5.1: Growth Strategy

Growth platforms are specifically named initiatives selected by a business organization to fuel revenue and earnings growth.

Learning Objective

Distinguish between the varying integrations and diversifications that allow businesses to pursue strategic growth

Key Points

• Strategic growth platforms are long-term initiatives for high-scale revenue increases. Generic examples of commonly selected strategic-growth platforms include pursuing specific and new product areas or entering new distribution channels.
• Diversification is a form of corporate strategy that seeks to increase profitability through greater sales volume obtained from new products or new markets.
• Market development strategy entails expanding the current incumbent market through new users or new uses.
• Market penetration occurs when a company penetrates a market in which current products already exist, enabling the business to compete head to head with incumbents in the market.
• New product development (NPD) is the internal process of bringing a new product to market.
• Integration, either horizontal or vertical, is a merger or acquisition process of entering new, related industries (for example, acquiring a supplier or a competitor in a related industry).

Key Terms

vertical integration

The integrating of successive stages in the production and marketing process under the ownership or control of a single management organization.

diversification

A corporate strategy in which a company acquires or establishes a business other than that of its current product.

horizontal integration

The merger or acquisition of new business operations.

Growth platforms are specifically named initiatives selected by a business organization to fuel revenue and earnings growth. Growth platforms may be strategic or tactical. Strategic growth platforms are longer-term initiatives for high-scale revenue increases. Generic examples of commonly selected strategic growth platforms include pursuit of specific and new product areas, entry into new distribution channels, vertical or horizontal integration, and new product development. Illustrative examples of growth platforms include:

• Apple Computer’s targeting of “personal music systems” to accelerate growth faster than with its personal computer business alone.
• IBM’s coining of the term “e-business,” and its subsequent use as the organizing theme for all that the company did in the late 1990s.
• Google’s entry into the operating system and laptop realms.

Wikipedia growth goals and projections

These graphs show goals and projections for growth for Wikipedia visitors and contributors from The Bridgespan Group for Strategy Development. The graph in the left panel shows the target growth trajectory in number of visitors, from less than 500 million to over 600 million. The graph in the right panel shows an overall increase in the number of contributors across all Wikipedias, with more growth indicated for the already higher-traffic Wikipedias.

Types of Strategies

There are a number of different growth strategies, but the most common are:

• Horizontal integration – The merger or acquisition of new business operations. An example of horizontal integration would be Apple entering the search-engine market or a new industry related to laptops and smartphones.
• Vertical integration – Integrating successive stages in the production and marketing process under the ownership or control of a single management organization. An example might include a gas-station company acquiring a oil refinery.
• Diversification – A corporate strategy in which a company acquires or establishes a business other than that of its current product. Diversification can occur either at the business-unit level or at the corporate level. At the business-unit level, diversification is most likely to involve expansion into a new segment of an industry in which the business already competes. At the corporate level, it generally means entrance into a promising business outside the scope of the existing business unit.

Other Product / Market Growth Types

Market Penetration

Market penetration occurs when a company penetrates a market in which current products already exist. This strategy generally requires great competitive strength, a strong brand, or both, as most market penetrations demand actively taking market share from current incumbents. It is an aggressive and often risky approach to growth.

Market Development Strategy

Market development strategy entails expanding the potential market through new users or new uses for a product. The strategy is best accomplished through identifying unique niche needs in a specific type of user and filling those needs. Market research is critical in development strategies. New users can be defined as new geographic segments, new demographic segments, new institutional segments, or new psychographic segments.

New Product Development

In business and engineering, new product development (NPD) is the process of developing, researching, and bringing a new product to market. A product is a set of benefits offered for exchange and can be tangible (that is, something physical you can touch) or intangible (for example, a service, experience, or belief). Identifying new needs or new ways of filling them and developing a new process or product that accomplishes this aim are the goal of this growth strategy. NPD requires investment in research and development, usually over the long term, and extensive trial and error.

12.5.2: Consolidation Strategy

In business, consolidation refers to the mergers and acquisitions of many smaller companies into much larger ones for economic benefit.

Learning Objective

Explain the relevance of consolidation from a strategic management perspective

Key Points

• Mergers and acquisitions (M&A) is an aspect of corporate strategy dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location, or acquire new sectors or locations.
• Consolidation occurs when two companies combine to form a new enterprise altogether, eliminating competition and creating broader economies of scale or scope.
• Generally speaking, a merger is a combination of organizations which each abandons its previous brand and business models, creating a new organization with the combined capacities of each.
• In an acquisition, one organization buys out another, with the acquired business usually placing its processes under the brand name of the acquirer.
• The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. However, on average and across most commonly studied variables, M&A activity does necessarily not improve financial performance.
• Because of the costs involved, consolidation is a very high-level strategic decision. All stakeholders on both ends should be consulted, and agreements will often take many months or years to conclude.

Key Terms

acquisition

The act or process of acquiring.

consolidation

The act or process of consolidating, making firm, or uniting; the state of being consolidated; solidification; combination.

merger

The legal union of two or more corporations into a single entity, with assets and liabilities typically assumed by the buying party.

Consolidation (or amalgamation) is the act of merging two or more organizations into one. In strategic management, it often refers to the mergers and acquisitions of many smaller companies into much larger ones. Consolidation occurs when two companies combine to form a new enterprise altogether; neither of the previous companies survives independently. The logic driving consolidation is the creation of economies of scale, economies of scope, new locations, new technology, or some other form of increased competitive capacity.

Mergers and Acquisitions

Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management that deal with the buying, selling, dividing, and combining of different companies and similar entities. This activity can help an enterprise grow rapidly in its sector or location of origin or expand into a new field or new location. M&A is different from joint ventures and other forms of strategic alliance, as mergers or acquisitions aim to create a single organization.

The distinction between a “merger” and an “acquisition” has become increasingly blurred in various respects (particularly in terms of the ultimate economic outcome), although it has not completely disappeared. Generally speaking, a merger is a combination of organizations in which each abandons its previous brand and business models, creating a new organization with the combined capacities of each one. In an acquisition, one organization buys out another, with the acquired company usually placing its processes under the brand name of the acquirer.

Mergers and acquisitions of U.S. Banks

This diagram of bank mergers in the United States shows how extensive the consolidation of various companies has been. What start as more than 50 distinct companies have eventually consolidated into fewer than 20.

Merger Dynamics

In the pure sense of the term, a merger happens when two firms, often about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a “merger of equals.” Both companies’ stocks are surrendered and new company stock is issued in its place. For example, in the 1999 merger of Glaxo Wellcome and SmithKline Beecham, both firms ceased to exist independently; a new company, GlaxoSmithKline, was created.

The classic example of consolidation is the merger of Bell Atlantic with GTE, out of which resulted Verizon Communications. Not every merger with a new name is successful. By consolidating into YRC Worldwide, the combined company lost the considerable value of both Yellow Freight and Roadway Corp.

Rationale

The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. The following motives are considered to improve financial performance: economy of scale, economy of scope, increased revenue or market share, cross-selling, synergy, taxation, geographical or other diversification, resource transfer, vertical integration, and hiring.

However, on average and across the most commonly studied variables, acquiring firms’ financial performance does not positively change as a function of their acquisition activity (King, D. R.; Dalton, D. R.; Daily, C. M.; Covin, J. G. 2004. “Meta-analyses of Post-acquisition Performance: Indications of Unidentified Moderators.” Strategic Management Journal 25 (2): 187–200. doi:10.1002/smj.371). Other motives for merger and acquisition that may not add shareholder value include diversification, manager overconfidence, empire-building, and management compensation.

Managerial Implications

Because of the costs involved, consolidation is a very high-level strategic decision. All stakeholders in both organizations should be consulted, and agreements will often take many months or years to conclude. Cultural conflicts between two different organizations are not uncommon, as the mission, vision, and values of the individuals and groups within them are likely to differ. Managing this type of change strategically is complex and rife with conflict. Mismanagement during these processes can minimize the potential synergistic gains and reduce the efficacy of the new strategic plan.

12.5.3: Global Strategy

Global strategy, as defined in business terms, is an organization’s strategic guide to pursuing various geographic markets.

Learning Objective

Explain the concept of global strategy within the context of international business and a globalized economy

Key Points

• A global strategy may be appropriate in industries where firms face strong pressures to reduce costs but weak pressures for local responsiveness, allowing these firms to sell a standardized product worldwide.
• Companies using a global strategy may achieve economies of scale to improve margins or low price points.
• Globalization is not limited to cost leadership. Differentiation strategies also enable economies of scope, either fulfilling different needs in different markets with a similar series of products, or developing new products based upon the needs and consumption habits of a new market.
• Other primary strategic reasons for globalization are to build supplier relationships, to improve access to raw materials (unique to a given region), and to cut costs by relying on other regions’ specializations.
• With global markets in mind, strategic managers must expand their perspective and use varied models to generate different strategies for different places.

Key Terms

fixed costs

A cost of business which does not vary with output or sales; overheads.

centralized

Having power concentrated in a single, central authority.

multinational

Operating, or having subsidiary companies in multiple countries (especially more than two).

Global strategy, as defined in business terms, is an organization’s strategic guide to pursuing various geographic markets. A global strategy should address the following questions: What should be the extent of an organization’s market presence in the world’s major markets? How can the organization build the necessary global presence? What are the optimal locations around the world for the various value-chain activities? How can the organization turn a global presence into global competitive advantage?

When to Go Global

Cost Leadership

A global strategy may be appropriate in industries where firms face strong pressures to reduce costs but weak pressures to respond locally; globalization therefore allows these firms to sell a standardized product worldwide. By expanding to a broader consumer base, these firms can take advantage of scale economies (cost advantages that an enterprise obtains due to expansion) and learning-curve effects because they are able to mass-produce a standard product that can be exported (providing that demand is greater than the costs involved).

Market Expansion

Globalization is not limited to cost leadership, however. Differentiation strategies also enable economies of scope, either fulfilling different needs in different markets with a similar series of products, or developing new products based upon the needs and consumption habits of a new market. Differentiation as part of a global strategy will often require localization, as organizations must adapt to consumer tastes better to compete in the new country. For example, Coca Cola tastes different depending on the country where it is bought because of differences in local preferences.

Sourcing

Other popular and primary strategic reasons for globalization include building supplier relationships, improving access to raw materials (unique to a given region), and cutting costs by using other regions’ specializations. Starbucks sources coffee beans from all over the world, as climate dramatically affects the type and quality of the bean. The globalization strategy of Starbucks—while it includes selling in many countries—is hugely depending on global sourcing, and strategic managers must carefully monitor this process for costs and benefits.

Global strategies require firms to coordinate tightly their product and pricing strategies across international markets and locations; therefore, firms that pursue a global strategy are typically highly centralized.

Corporate Strategy Implications

With global markets in mind, strategic managers must expand their perspective and use varied models to generate different strategies for different places. For example, companies must now conduct a PESTEL analysis for each region in which they operate and recognize expense and competition deviations between regions. For example, tariffs in country A may be much higher than country B, but country B has fewer individuals willing to pay a high price for the good the organization is selling. Managers must conduct a cost/benefit analysis to identify which country actually offers the best profit potential. These analyses are how strategists incorporate global concerns into strategic management.

Gross domestic product (GDP) worldwide

The map identifies GDP (nominal) in different countries;countries with higher GDPs offer high consumer spending opportunities for multinational enterprises. The U.S. and China have the highest GDPs.

12.5.4: Cooperative Strategy

A strategic alliance is a cooperation where each member expects the benefit from cooperation will outweigh the cost of individual efforts.

Learning Objective

Identify the steps involved in forming a strategic alliance to employ cooperative strategies

Key Points

• A strategic alliance is a relationship between two or more parties to pursue a set of agreed-upon goals or to meet a critical business need while remaining independent organizations. This form of cooperation lies between mergers and acquisitions and organic growth.
• Partners may provide the strategic alliance with resources such as products, distribution channels, manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual property.
• Upper management is tasked with the complex process of identifying good partners and generating agreements of mutual benefit. Strategic alliances can be high-cost, complex strategic components.
• Strategic alliances allow each partner to concentrate on its own best capabilities, learn and develop other competences, and assure adequate suitability of resources and competencies.

Key Term

alliance

The state of being allied; the act of allying or uniting; a union or connection of interests between families, states, parties, etc.

A strategic alliance is a relationship between two or more parties to pursue a set of agreed-upon goals or to meet a critical business need while remaining independent organizations. This form of cooperation lies between mergers and acquisitions (M&A) and organic growth.

Reasons for Strategic Alliance

The alliance is a cooperation or collaboration that aims for a synergy where each partner hopes that the benefits from the alliance will be greater than those from individual efforts. Partners may provide the strategic alliance with resources such as products, distribution channels, manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual property.

The alliance often involves technology transfer (access to knowledge and expertise), economic specialization (David C. Mowery, Joanne E. Oxley, Brian S. Silverman. Strategic Alliances and Interfirm Knowledge Transfer. Winter 1996. Strategic Management Journal, Vol. 17, Special Issue: Knowledge and the Firm, pp. 77-91), shared expenses, and shared risk.

U.S. patents from 1790-2010

The above chart highlights the total patents granted over time in the U.S. Because the number of patents has increased in recent years, technology transfers in strategic alliances have become more common.

Cooperative sourcing is a collaboration or negotiation between different companies with similar business processes. To save costs, the competitor with the best production capability can insource the business process of the other competitors. This practice is especially common in IT-oriented industries as a result of low to no variable costs, e.g. banking. Since all of the negotiating parties can be outsourcers or insourcers, the main challenge in this collaboration is to find a stable coalition and the company with the best production function. High switching costs, costs for searching potential cooperative sourcers, and negotiating may result in inefficient solutions.

Forming a Strategic Alliance

Upper management is tasked with the developing complex interactive strategies when entering a strategic alliance. Aligning stakeholders from different businesses and ensuring the costs do not outweigh the benefits requires careful managerial consideration. The following steps highlight key aspects of the strategic alliance process:

• Strategy development involves studying the alliance’s feasibility, objectives, and rationale; it also entails focusing on the major issues and challenges and development of resource strategies for production, technology, and people. It requires aligning alliance objectives with the overall corporate strategy.
• Partner assessment involves analyzing a potential partner’s strengths and weaknesses; creating strategies to accommodate all partners’ management styles; preparing appropriate partner selection criteria; understanding a partner’s motives for joining the alliance; and addressing resource capability gaps that may exist for a partner.
• Contract negotiation involves determining whether all parties have realistic objectives; forming high-caliber negotiating teams; defining each partner’s contributions and rewards as well as protecting any proprietary information; addressing termination clauses and penalties for poor performance; and highlighting the degree to which arbitration procedures are clearly stated and understood.
• Alliance operations comprise addressing senior management’s commitment; finding the caliber of resources devoted to the alliance; linking budgets and resources to strategic priorities; measuring and rewarding alliance performance; and assessing the performance and results of the alliance.
• Alliance termination entails winding down the alliance—for instance, when its objectives have been met or cannot be met or when a partner adjusts priorities or reallocates resources elsewhere.

Potential Benefits of Strategic Alliances

Benefits of strategic alliances vary according to each business’s strengths and objectives and may include:

• Pooling expensive resources and share development or R & D costs on new products
• Locking in supply chains
• Building credibility with customers (“Our strategic partners include…”)
• Allowing each partner to concentrate on activities that best match its capabilities
• Learning from partners and developing competencies that may be more widely exploited elsewhere
• Creating adequate suitability of resources and competencies for an organization to survive

12.5.5: E-Business Strategy

In the emerging global economy, e-business has become an increasingly necessary component of business strategy.

Learning Objective

Define and explain the general value chain of an e-business strategy and its advantages

Key Points

• The integration of information and communications technology (ICT) has revolutionized relationships within organizations and among organizations and individuals. It has also enhanced productivity, encouraged greater customer participation, enabled mass customization, and reduced costs.
• Companies use ICT to enhance e-business, which includes any process that a business organization (either a for-profit, governmental, or non-profit entity) conducts over a computer-mediated network.
• E-business enhances three primary processes: those related to production, customer focus, and internal management.

Key Terms

e-business

A business that operates partially or primarily over the Internet, usually providing services to other businesses.

e-learning

An online platform for training modules, whether internal or external to an organization.

e-commerce

Commercial activity conducted via the Internet.

The term electronic business (commonly referred to as E-business or e-business) is sometimes used interchangeably with e-commerce. In fact, e-business encompasses a broader definition that includes not only e-commerce, but customer relationship management (CRM), business partnerships, e-learning, and electronic transactions within an organization.

Electronic-business methods enable companies to link their internal and external data-processing systems more efficiently and flexibly, to work more closely with suppliers and partners, and to better satisfy the needs and expectations of customers. In practice, e-business is more than just e-commerce. While e-business refers to a strategic focus with an emphasis on the functions that occur using electronic capabilities, e-commerce is a subset of an overall e-business strategy.

E-Business Process

E-business involves business processes that span the entire value chain: electronic purchasing and supply-chain management, electronic order processing, customer service, and business partner collaboration. Special technical standards for e-business facilitate the exchange of data between companies. E-business software allows the integration of intrafirm and interfirm business processes. E-business can be conducted using the Internet, intranets, extranets, or some combination of these.

Automated online assistant

In e-commerce, electronic (i.e., online) purchasing and ordering can be enhanced by the use of automated online assistants like this. This greatly reduces the burden on the company’s customer service team, allowing them to deal with only the most highly escalated cases.

In the emerging global economy, e-commerce and e-business have become increasingly necessary components of business strategy and strong catalysts for economic development. The integration of information and communications technology (ICT) in business has revolutionized relationships within organizations and those among organizations and individuals. Specifically, the use of ICT in business has enhanced productivity, encouraged greater customer participation, and enabled mass customization.

Advantages of E-Commerce

E-business enhances three primary processes:

1. Production processes including procurement, ordering and replenishment of stocks; processing of payments; electronic access to suppliers; and production control processes
2. Customer-focused processes including promotional and marketing efforts, Internet sales, customer purchase orders and payments, and customer support
3. Internal management processes including employee services, training, internal information-sharing, videoconferencing, and recruiting. Electronic applications enhance information flow between production and sales forces to improve sales-force productivity. ICT improves the efficiency of work-group communications and electronic publishing of internal business information.

12.6: The Planning Process

12.6.1: Defining Strategic Planning

Strategic planning is concerned with defining company goals and determining the resources needed to achieve them.

Learning Objective

Assess the definition of planning in context with strategy and the various planning process approaches

Key Points

• To determine the direction of the organization, it is necessary to understand its current position and the possible avenues through which it can pursue a particular course of action.
• There are many approaches to strategic planning, but typically either the situation-target-proposal approach or the draw-see-think-plan approach is used to generate a plan’s structure.
• The primary purpose of planning is to create universal buy-in and understanding of the objectives, and to put operational processes in place to guide the organization towards their achievement.

Key Terms

plan

A set of intended actions, usually mutually related, through which one expects to achieve a goal.

allocate

To distribute according to a plan.

strategy

A plan of action intended to accomplish a specific goal.

Strategic planning is an organization’s process of defining its strategy and making decisions on how to allocate resources to pursue that strategy. To determine the direction of the organization, it is necessary to understand its current position and the possible avenues through which it can pursue a particular course of action. Strategic planning generally deals with at least one of three key questions:

• What do we do?
• For whom do we do it?
• How do we excel?

In many organizations, this is viewed as a process for determining where the organization is going over the next year or, more typically, three to five years, although some extend their vision to 20 years. The last question—how do we excel?—is critical to achieving competitive advantage, and it should be answered clearly and practically in the planning process prior to extensive investment in resources.

Components of a Strategic Plan

Planning is concerned with defining goals for a company’s future direction and determining the resources required to achieve those goals. To meet the goals, managers will develop marketing and operational plans inclusive of key organizational values (vision, mission, culture, etc.).

Common components of a business plan include external and internal analyses, marketing and branding, investments, debt, resource allocation, suppliers, production processes, competition, and research and development. While different business models include different components in their planning, based on unique organizational or industry needs, the central theme is that all aspects of the strategy should be researched and discussed prior to incurring the costs of operations.

Business plan

This image summarizes some of the factors that should be considered in the creation of a business plan, such as a company’s mission and purpose, personnel, financial resources, market and customer base, competition, and strengths and weaknesses.

Planning Process

There are many approaches to strategic planning, but typically one of the following approaches is used.

Situation-Target-Proposal

This method involves the following steps:

• Situation: Evaluate the current situation and how it came about.
• Target: Define goals and objectives (sometimes called ideal state).
• Proposal: Map a possible route to the goals and objectives.

Draw-See-Think-Plan

This method involves addressing the following questions:

• Draw: What is the ideal state or the desired end state?
• See: What is today’s situation? What is the gap between today’s situation and the ideal state, and why?
• Think: What specific actions must be taken to close the gap between today’s situation and the ideal state?
• Plan: What resources are required to execute these specific actions?

12.6.2: Benefits of Strategic Planning: Focus, Action, Control, Coordination, and Time Management

Planning enables companies to achieve efficiency and accuracy by coordinating efforts and managing time effectively.

Learning Objective

Identify the critical benefits derived through utilizing business and marketing plans in strategic management

Key Points

• Planning is a management process concerned with defining goals for a company’s future direction and determining the resources required to achieve those goals. Managers may develop a variety of plans (business plan, marketing plan, etc.) during the planning process.
• Achieving a vision requires coordinated efforts that adhere to a broader organizational plan. This is enabled through consistent strategies that are supported by staff at all levels.
• Planning enables increased focus on, and coordinated action toward, competitive strategies, while minimizing wasted time and ensuring there are benchmarks for the control process.
• Planning typically offers a unique opportunity for information-rich and productively focused discussions between the various managers involved. The plan and the discussions that arise from it provide an agreed context for subsequent management activities.

Key Terms

business plan

A summary of how a business owner, manager, or entrepreneur intends to organize an endeavor and implement activities necessary and sufficient to achieve success.

time management

The management of time in order to make the most of it.

planning

The act of formulating a course of action.

The planning process is concerned with defining a company’s goals and determining the resources necessary to achieve those goals. Achieving a vision requires coordinated efforts that adhere to a broader organizational plan. This is enabled through consistent strategies that are supported by staff at all levels. To meet business goals, managers develop business plans not only to reach targets but also to strengthen and change public perception of the company’s brand.

Integrated business plan

This business plan takes aspects of a business and identifies clear goals for each: e.g., for the technology to move from being weak and non-integrated to enabling workflows, and for the business’s focus to transition from being inwardly to outwardly focused.

Since they have achieved defined goals through the planning process, managers and employees can focus and control their efforts and their resources, follow determined plans of action, coordinate activities between divisions, and use time management to meet specific goals. Planning helps to achieve these goals or targets by efficiently and effectively using available time and resources. In short, planning, if executed properly, should lead to the following benefits:

Focus

There are a wide variety of activities an organization (or the individuals within the organization) might viably pursue. While there is value in the pursuit of many activities, understanding which ones the organization should focus on to leverage organizational competencies and align with market research requires careful planning and delegation. This is how planning achieves focus.

Coordinated Action

If department A is reliant on inputs from department B, department A cannot utilize department B’s work without coordination. If department B has too much work and department A too little, there is poor interdepartmental coordination. This is alleviated through detail-oriented planning processes.

Control

The control process is based on benchmarks, which is to say that controlling requires a standard of comparison when viewing the actual operational results. Control relies on the planning process to set viable objectives, which can then be worked towards through controlling operations.

Time Management

Time management underlines the importance of maximizing the use of time to minimize the cost of production. If a full-time employee can accomplish their work within 32 hours, the planning process can find meaningful use for their remaining time. Costs can be lowered and productivity increased by ensuring that each element in the operational process functions according to ideal time constraints.

The Process Itself

Perhaps the most important benefit of developing business and marketing plans is the nature of the planning process itself. This typically offers a unique opportunity, a forum, for information-rich and productively focused discussions between the various managers involved. The plan and the discussions that arise from it provide an agreed context for subsequent management activities, even those not described in the plan itself.

12.6.3: Overview of Inputs to Strategic Planning

Strategic plans can take the form of business or marketing plans, and consultants and industry experts are used in their development.

Learning Objective

Review the various tools for effective plan development, including stakeholder input, consultants, and data collection

Key Points

• In most corporations, there are several levels of management, including the corporate, business, functional, and strategic levels.
• Strategic management is the highest of these levels in the sense that it is the broadest—it applies to all parts of the firm and incorporates the longest time horizon.
• A marketing plan is a written document that details the actions necessary to achieve one or more marketing objectives.
• A business plan is a formal statement of a set of business goals, the reasons they are attainable, and the plan for reaching them.
• Available business resources for creating a plan include industry experts, consultants, and stakeholder input, which can help enable an objective and comprehensive view of internal and external factors.

Key Term

tactical planning

An organization’s process of determining how to optimize current resources and operations.

Strategy Hierarchy

In most corporations, there are several levels of management. Strategic management is the highest of these levels in the sense that it is the broadest—it applies to all parts of the firm and incorporates the longest time horizon. It gives direction to corporate values, corporate culture, corporate goals, and corporate missions. Under the broad corporate strategy are business-level competitive strategies and functional unit strategies.

• Corporate strategy refers to the overarching strategy of the diversified firm.
• Business strategy refers to the aggregated strategies of a single business firm or a strategic business unit (SBU) in a diversified corporation.
• Functional strategies include marketing strategies, new-product development strategies, human resource strategies, financial strategies, legal strategies, supply-chain strategies, and information-technology management strategies. The emphasis is on short-term and medium-term plans and is limited to the domain of each department’s functional responsibility. Each functional department attempts to do its part to meet overall corporate objectives, so to some extent their strategies are derived from broader corporate strategies.

Many companies feel that a functional organizational structure is not an efficient way to organize activities, so they often re-engineer according to processes or SBUs. A strategic business unit is a semi-autonomous unit that is usually responsible for its own budgeting, new product decisions, hiring decisions, and price setting. An SBU is treated as an internal profit center by corporate headquarters.

Business Plans

A business plan is a formal statement of a set of business goals, the reasons they are attainable, and the plan for reaching them. It may also contain background information about the organization or team attempting to reach those goals.

For example, a business plan for a nonprofit might discuss the fit between the business plan and the organization’s mission. Banks are quite concerned about defaults, so a business plan for a bank loan will build a convincing case for the organization’s ability to repay the loan. Venture capitalists are primarily concerned about initial investment, feasibility, and exit valuation. A business plan for a project requiring equity financing will need to explain why current resources, upcoming growth opportunities, and sustainable competitive advantage will lead to a high exit valuation.

Preparing a business plan draws on a wide range of knowledge from many different business disciplines: finance, human resource management, intellectual-property management, supply-chain management, operations management, and marketing. It can be helpful to view the business plan as a collection of subplans, one for each of the main business disciplines.

Marketing Plans

A marketing plan is a written document that details the actions necessary to achieve one or more marketing objectives. It can be for a product, a service, a brand, or a product line. Marketing plans span between one and five years.

A marketing plan may be part of an overall business plan. Solid strategy is the foundation of a well-written marketing plan, and one way to achieve this is by using a method known as the seven Ps (product, place, price, promotion, physical environment, people, and process). A product-oriented company may use the seven Ps to develop a plan for each of its products. A market-oriented company will concentrate on each market. Each will base its plans on the detailed needs of its customers and on the strategies chosen to satisfy those needs.

The seven Ps

In marketing, the general process of identifying and approaching a target market is captured through the seven Ps: Place, Price, Promotion, People, Process, Physical Evidence, and Product.

Tools for Planning

Often discussed in tools for planning are models that measure the internal and external environments (e.g. Porter’s Five Forces, SWOT, Value Chain, etc.). These models create forward-looking projections based on past and present data; therefore, they are useful only once enough data have been collected. Because of this, tools for planning largely focus on generating enough data to construct valid recommendations. These tools can include:

• Industry experts: Whether internal employees or external consultants, a few individuals with extensive experience in a given industry are valuable resources in the planning process. These industry experts can move beyond the PESTEL and Porter’s Five Forces frameworks, making intuitive leaps as to the trajectory of the industry.
• Consultants: Consultants are commonly brought in during strategy formulation and for a variety of other reasons. Most important of these would be providing an objective lens for internal affairs. It is difficult to see the whole house from inside the house, and upper management can utilize an external opinion to ensure they are seeing operations clearly and objectively.
• Inclusion of stakeholders: Upper management will want as much information as possible from everyone involved. Some examples include consumer surveys on satisfaction, supplier projections for costs over a given time frame, consumer inputs on needs still unfilled, and shareholder views. The inclusion of stakeholders offers a variety of tools, each of which may or may not be a useful input depending on the context of the plan.

12.6.4: Responding to Uncertainty in Strategic Planning

Uncertainty exists when there is more than one possible outcome; it is best managed using scenario-planning tools.

Learning Objective

Recognize the inevitability of uncertainty in strategic planning, alongside planning for effective responses to these uncertainties

Key Points

• Strategic management is having a clear view, based on the best available evidence and on defensible assumptions, of what is possible to accomplish within the constraints of a given set of circumstances.
• Initial ideas about corporate objectives may have to be altered if there is no feasible implementation plan that will meet with a sufficient level of acceptance among stakeholders, or if the necessary resources are not available, or both.
• Scenario planning starts by separating things believed to be known, at least to some degree, from those considered uncertain or unknowable.

Key Terms

uncertainty

A state of having limited knowledge such that it is impossible to exactly describe an existing state or future outcomes or to determine which of several possible outcomes will happen.

tactical planning

An organization’s process of determining how to optimize current resources and operations.

qualitative

Described in terms of characteristics and attributes rather than numbers and quantities.

Uncertainty

Management specialists define uncertainty as a state of having limited knowledge such that it is impossible to exactly describe an existing state or future outcomes or to determine which of several possible outcomes will happen. It is still possible, however, to measure uncertainty—by assigning a probability to each possible state or outcome to estimate its likelihood.

In the past, strategic plans have often considered only the “official future,” which was usually a straight-line graph of current trends carried into the future. Often the trend lines were generated by the accounting department and lacked discussions of demographics or qualitative differences in social conditions. These simplistic guesses can be good in some ways, but they fail to consider qualitative social changes that can affect an organization.

Instead of just following trend lines, scenarios focus on the collective impact of many factors. Scenario planning helps to understand how the various strands of a complex tapestry move if one or more threads are pulled. A list of possible causes, like a fault-tree analysis, tends to downplay the impact of isolated factors. When factors are explored together, certain combinations magnify the impact or likelihood of other factors. For instance, an increased trade deficit may trigger an economic recession, which in turn creates unemployment and reduces domestic production.

Fault tree

Fault trees can help outline possible outcomes. This fault tree visually lays out all the different steps at which something could go wrong in a spacecraft’s flight, from the spacecraft itself spinning to fast to motor failure to a valve being stuck open.

Responding to Uncertainty

Organizations need to cope with issues that are too complex to be fully understood, yet significant decisions need to be made that are based on a limited understanding or limited information. There are several ways of dealing with this.

Be Iterative

The process of developing organizational strategy must be iterative. That is, it should involve toggling back and forth between questions about objectives, implementation planning, and resources. For example, an initial plan for a project may have to be adjusted if the budget changes.

Use Scenario Planning

Scenario planning starts by separating things believed to be known, at least to some degree, from those considered uncertain or unknowable. The first component, knowledge, includes trends, which cast the past forward, recognizing that the world possesses considerable momentum and continuity. The second component, uncertainties, involves indeterminable factors such as future interest rates, outcomes of political elections, rates of innovation, fads in markets, and so on. The art of scenario planning lies in blending the known and the unknown into a limited number of internally consistent views of the future that span a very wide range of possibilities.

Numerous organizations have applied scenario planning to a broad range of issues, from relatively simple, tactical decisions to the complex process of strategic planning and vision building. Scenario planning for business was originally established by Royal Dutch/Shell, which has used scenarios since the early 1970s as part of its process for generating and evaluating strategic options. Shell has been consistently better in its oil forecasts than other major oil companies, and predicted the overcapacity in the tanker business and Europe’s petrochemicals earlier than its competitors.

Accept Uncertainty

It serves little purpose to pretend to anticipate every possible consequence of a corporate decision, every possible constraining or enabling factor, and every possible point of view. What matters for the purposes of strategic management is having a clear view, based on the best available evidence and on defensible assumptions, of what is possible to accomplish within the constraints of a given set of circumstances. As the situation changes, some opportunities for pursuing objectives will disappear and others will arise. Some implementation approaches will become impossible, while others, previously impossible or unimagined, will become viable. Strategic management adds little value, and may do harm, if organizational strategies are designed to be used as detailed and infallible blueprints for managers.

12.7: Types of Plans

12.7.1: Overview of Types of Strategic Plans

The broader overview of strategic plans, as well as the five subgroups within strategic planning, provide businesses with direction.

Learning Objective

Differentiate between the five general planning frames and recognize considerations that must be made prior to planning

Key Points

• Strategic plans are what communicate the corporate strategy, direction, and resource allocation. There are generally five subgroups of strategic plans.
• Short-range plans generally constitute a specific time frame in which a specific series of operations will be carried out, assessed, and measured.
• Long-range plans are arguably the most crucial to the continued success of a business, ultimately highlighting the way in which operations interact to achieve long-term profitability and returns on investment.
• Operational plans comprise the most specific subgroup of strategic planning, describing the specific objectives and milestones a business should consider in executing each particular operation. Operational plans are often used by control professionals.
• Standing plans are based on the operations that must be repeated indefinitely within a business or corporation.
• As opposed to standing plans, single-use plans cover a specific operation or process that is an outlier to normal operations.

Key Terms

strategic planning

An organization’s process of defining its direction and making decisions on allocating resources to pursue that direction.

single-use plans

A strategy for achieving an objective that can only be used in one situation.

standing plan

A strategy for achieving an objective that can be continually used or modified.

Strategic management is primarily concerned with the planning and execution processes that lead to the effective operations of a business. Strategic management leverages strategic planning in order to design and execute a variety of plans specifically created to approach various facets of the business and competitive environment. It is worth analyzing the broader overview of strategic plans, as well as the five subgroups within strategic planning that provide businesses with an outline of their strategic direction.

Strategic plans are what communicate the corporate strategy, direction, and resource allocation.

Factors of a strategic plan

This illustration summarizes the various factors that must be considered in constructing a corporation’s strategic plan. At the pinnacle of the pyramid is the most important element of any strategic plan—the vision. Under that, in descending order, are accountability, stakeholder involvement, tools and skills, enabling behavior, and measures and processes.

Specific Types of Plans

Following the generation of a vision and mission statement, and the subsequent operations that will allow these to be achieved, smaller facets of the planning process begin to come into play. These include five general planning frames, which can be applied to different aspects of the operational process:

• Short-range plans: Short-range plans generally apply to a specific time frame in which a specific series of operations will be carried out, assessed, and measured. The standard short-range plan will represent annual or semiannual operations with a short-term deliverable. These short-term plans cover the specifics of each day-to-day operation.
• Long-range plans:Long-range plans are arguably the most crucial to the continued success of a business, ultimately highlighting the way in which operations interact to achieve long-term profitability and returns on investment. As corporations grow in size and complexity, so do the long-range plans that constitute the interaction of individual processes. Long-range plans are those most closely related to the overall strategic-planning process.
• Operational plans:Operational plans are the most specific subset of strategic planning, describing the specific objectives and milestones a business should consider in executing each particular operation. Operational plans establish both the budgetary resources necessary for execution and the tangible and easily assessed objectives that can define the success of any given project.
• Standing plans:Standing plans are based on the operations that must be repeated indefinitely within a business or corporation. Standing plans govern the processes that occur regularly, providing an overview for consistent activities.
• Single-use plans:As opposed to standing plans, single-use plans cover a specific operation or process that is an outlier to normal operations. In all likelihood, a single-use plan will never need to be repeated and will simply cover the content involved in one circumstance.

By combining all of these plans—often a few of each subgroup, depending on the scale and complexity of a business—a general strategic overview can be obtained. The interaction of all of these plans constitute the overall strategic trajectory of a business, measuring profitability and efficiency as the company executes operations.

12.8: Planning Tools

12.8.1: Overview of Strategic Planning Tools

Strategists have developed a large array of tools useful in plan formulation, all of which provide unique insights and advantages.

Learning Objective

Outline the wide array of useful tools to improve upon the scope and effectiveness of the planning process within the context of strategic management

Key Points

• Forecasting, consisting of the basic concept of projecting future outcomes, is the most common tool in the strategic tool belt.
• Scenario planning is where strategists construct various scenarios to test out the potential trajectories of a specific operational plan.
• Contingency planning can be simply described as the back-up plan, while participatory planning is the primary plan. If (or, more likely, when) things do not go according to plan, a contingency plan should be in place.
• Management by objectives (MBO) is the process of defining, disseminating, and implementing the objectives that an organization has identified as strategic.
• The SMART model identifies specific goals, measures inputs and outputs, ensures that the goals are attainable and relevant to the mission of the company, and constructs a timeline.
• Incorporating concepts such as forecasting and benchmarking in conjunction with larger corporate-strategy frameworks such as SMART goals and MBO will equip strategists with a strong short-term and long-term approach.

Key Terms

forecasting

Estimating how a condition will be in the future.

benchmark

A standard that allows a manager to compare metrics, such as quality, time, and cost, across an industry and against competitors.

contingency plan

An alternative to be put into operation if needed, especially in case of an emergency or if a primary plan fails.

Strategists have developed a large array of tools useful in the assessment of strategic planning, all of which provide unique insights into the feasibility and profitability of a given operational project. Identifying these tools, and selecting which are most appropriate for determining the effectiveness or efficiency of a project, is a central responsibility of a strategic-management team.

Listed below are the main tools available for consideration along with a brief description of how each tool is useful.

Forecasting

Forecasting is the the most common strategic tool and it should be considered whenever projects are being designed. Forecasting, simply put, is projecting the future of a project by leveraging all of the available knowledge to generate a likelihood of success. It is useful to construct pro forma financial statements, which illustrate expected costs and revenues.

Scenario Planning

Scenario planning is an interesting tool with which strategists construct various scenarios to test out the potential trajectories of specific operational plans. One popular scenario application is called the zero-sum game, where the costs and revenues are equated to see at what level of cost or what level of revenue a zero-sum bottom line can be achieved. By benchmarking this situation against reality, strategists can see in which situations value can be captured.

Benchmarking

Benchmarking can be done qualitatively or quantitatively, and it is a comparative approach to strategy. Benchmarking usually requires the identification of a close competitor with similar strategic prerogatives so that the strategist can compare and contrast the two companies’ strengths and weaknesses, identifying strategies for improvements or competitive advantages.

Participatory and Contingency Planning

Contingency planning can be simply described as the back-up plan, while participatory planning is the primary plan. An excellent tool for strategists pursuing a particularly risky venture is to develop the primary objectives and strategy while simultaneously constructing a contingency plan that will limit the negative effects of failure. This offsets risk through finding various ways to achieve value regardless of the success of the overall venture. This requires creativity and a degree of adaptability.

Goal Setting

Goal setting, similar to MBO and SMART, is a simple method for strategists to establish and enforce specific goals within the organization or strategic business unit (SBU). Goal setting creates incentives for employees by identifying achievable end results, which drives the direction of the company towards commonly established goals. This theory was developed by Edwin A. Locke in the 1960s and is considered an “open” theory, which implies that new thoughts and developments may be layered on top of the original goal-setting framework.

Management by Objectives

MBO is the process of defining, disseminating, and implementing the objectives that an organization has identified as strategic. Objectives provide factual and achievable strategies that align with employee and manager goals in order to ensure that all participants are on the same page. It is also useful to set goals and a timeline to assess progress and ensure that each individual is achieving their segment of the plan.

SMART Goals

The SMART model aims to design goals that are specific, measurable, achievable, realistic, and time-targeted (SMART).

SMART criteria

Each component of the SMART model describes an effective attribute of a performance objective. Objectives will ideally conform to these expectations.

The SMART model identifies specific goals, measures inputs and outputs, ensures that the goals are attainable and relevant to the mission of the company, and constructs a timeline.

Though there are many other potential tools for strategists, these seven provide a strong framework for further development of strategic methodologies. Incorporating concepts such as forecasting and benchmarking in conjunction with larger corporate strategy frameworks such as SMART goals and MBO will equip strategists with a strong short-term and long-term approach.

12.9: The Planning Cycle

12.9.1: Planning a Project

Identifying stages in a project plan, complete with objectives, implementation, and assessment, is a primary responsibility of strategists.

Learning Objective

Outline the five basic stages in the planning cycle as derived within the field of strategic management

Key Points

• The initiation stage includes generating ideas, assessing the feasibility and profitability of the project, conceptualizing the operational benefits and bottom line, and getting approval and resources.
• Planning and design follows the initiation stage, bringing the project under the microscope to assess the smaller details. Planning predicts the time investment, costs, and specific resources required.
• The simplest stage in theory, and perhaps the most complicated in practice, is the execution stage. This requires integrating all of the identified inputs from the planning-and-design phase to construct the actual end product or service.
• In the monitoring and controlling phase, analysis of the efficiency and quality of the project cycle from a strategic perspective allows for the optimization of the operational process itself.
• At the end of the project-management cycle, the closing phase determines that the project no longer captures value and should be harvested or divested.
• This cycle is iterative, and, unless the project is harvested or divested, should be continuously assessed and altered whenever deemed necessary.

Key Terms

optimization

The design and operation of a system or process to make it as good as possible in some defined sense.

feasibility

The state of being possible.

forecast

An estimation of a future condition.

The stages of a project within the strategic-planning discipline provide a step-by-step approach to generating and implementing an effective strategy, for either a corporation or a strategic business unit (SBU). Implementing a framework for generating a project-planning cycle, complete with strategic objectives, implementation methods, and assessment, is a primary responsibility of strategic managers.

Project-planning cycle

As shown in the figure, there are five basic strategic management steps in the planning cycle.

The Steps in Strategic Planning

1. Initiation: The initiation stage includes generating the idea, assessing the feasibility and profitability of the project, conceptualizing the operational benefits and the bottom line, and getting approval and resources. This stage should determine the scope of the operation.
2. Planning and design: Planning and design brings the project under the microscope by assessing the smaller details. This stage includes predicting the time investment, costs, specific resources required, and the necessary inputs to achieve the outputs forecasted in the initiation stage. This stage is the most strategic in nature, mapping out the business processes in sufficient detail to effectively accomplish the required objectives.
3. Executing: The simplest stage in theory, and perhaps the most complicated in practice, is the execution stage. It involves the integration of all inputs identified in the planning-and-design stage to construct the actual end product or service. This integration should be in line with the framework established in the first two stages.
4. Monitoring and controlling: This can be thought of as the perfecting stage, in which analyzing the efficiency and quality of the project cycle from a strategic perspective allows for the optimization of operational processes. Monitoring the operation for ways to increase value can redirect the strategic-planning cycle back to the planning-and-design stage. This stage allows the process to run internally in a cyclical fashion, constantly adding improvements to capture more value.
5. Closing: The project-management cycle ends with the determination that the project no longer captures value and should be harvested or divested. This stage is the other possible result from the monitoring and controlling phase—that is, instead of being redirected back to the planning-and-design phase, the assessment shows that value is now being lost and it is no longer profitable to continue the process. Therefore, the project cycle is closed.

This step-by-step process highlights each feasible stage in the project-management cycle. By appropriately incorporating each stage of the model into the planning process, managers can effectively forecast the deliverable, and they can avoiding losing value by accurately assessing the margins that will be produced in a given strategic initiative. This allows for informed and knowledgeable decisions to be made at each relevant point in the operation.

11.4: Improving Communication Effectiveness

11.4.1: Learning to Speak

Learning Objective

Explain the difficulty of sending communications, with a particular focus on improving and enhancing’s one’s ability to communicate accurately and concisely

Key Points

• The ability to communicate clearly in speaking and in writing is one of the most valuable professional skills.
• Communicating effectively relies on credibility, which is undermined by grammar and spelling mistakes, incompleteness, and errors in logic.
• When sending a message, the communicator must keep in mind the target audience.

Key Terms

brevity

The quality of being brief in duration.

clarity

The state, or measure of being clear, either in appearance, thought or style; lucidity.

The ability to communicate effectively in speech and in writing is one of the most valuable professional skills. Sending messages and information so they are understood as intended and produce the desired effect demands certain technical competencies and interpersonal capabilities. Fortunately, these can be learned and honed through practice.

Communicating effectively relies on credibility. Mistakes in grammar and spelling, incompleteness, and errors in logic can have a negative impact on the audience’s perception of the sender’s credibility. As a result, the communicator’s ability to persuade or otherwise influence the recipient is diminished. Effective ways to learn precise, professional oral and written communication skills include:

1. having others, such as a supervisor, provide feedback on strengths and weaknesses as a communicator.
2. analyzing the strengths and techniques of excellent communicators.
3. imitating strong communicators.

Communicating in the Workplace

When sending a message, communicators must think of the target audience, being sure to use terms and phrases that readers or listeners will understand. For example, texts or e-mails should avoid using abbreviations that the receiver may not recognize. To respect others’ time, communication should aim for brevity and concision without sacrificing clarity and completeness. Using e-mail effectively poses particular challenges. Often, messages are poorly structured, missing specific subject lines, slow in getting to the point, or too long to warrant being read in their entirety.

It can be challenging to strike the right tone or avoid the wrong one in electronic communication. The absence of non-verbal cues, such as tone of voice or body language, means that written communication can be more easily misinterpreted and even cause offense. Consequently, important communications may warrant review by someone who can assess the tone and content and provide feedback.

Connecting via text message

In texting, reliance on abbreviations can obscure a point.

11.4.2: Learning to Listen

Learning Objective

Explain active and reflective listening as techniques for improving the effectiveness of oral communication

Key Points

• Communication is an activity that involves a both sender and an audience, or receiver. While the sender must focus on making sure the message is clear, the receiver has to show that the message is received and understood.
• Active listening is a process of attending carefully to what is being said and how the speaker says it.
• Reflective listening focuses on personal elements of communication rather than the abstract ideas. It deals with the emotional content of communication.

Key Terms

receiver

A person who receives a signal.

active listening

The process of attending carefully to what a speaker is saying, involving such techniques as accurately paraphrasing the speaker’s remarks.

Interpretation

An act of explaining what is obscure.

Effective oral communication is the responsibility of both the sender and the recipient. While the sender must focus on making sure the message is clear, the receiver has to show that the message is received and understood. For the sender, content, channel choice, and understanding of the audience matter most. For the recipient, listening skills are paramount. Listening is an interaction between speaker and listener. The listener’s use of active and reflective listening skills can help improve communication effectiveness.

Active Listening

Active listening is a process of attending carefully to what is being said. It also involves the listener observing the speaker’s behavior and body language. One way to demonstrate this attention is for the listener to show understanding by paraphrasing what the speaker has said. Paraphrasing can confirm the accuracy of the listener’s interpretation or identify the need for clarification. Conversely, when individuals show disinterest or distraction when someone is speaking, it reveals an absence of listening that can frustrate, annoy, and even anger the speaker.

Not listening

Failing to listen to a speaker can create anger, resentment, and misunderstanding.

Reflective Listening

Reflective listening focuses on personal elements of the communication rather than the abstract ideas. Reflective listening should be feeling-oriented and responsive. The listener should show empathy and concern for the person communicating. A good reflective listener concentrates on the discussion at hand while allowing the speaker to lead the communication. Verbal response is essential for reflective listening. Listeners should make statements that paraphrase what is said, clarify what appears to be implicit, and reflect the emotion or feeling they sense from the speaker. Being able to understand and articulate the meaning behind the words helps receivers better interpret the information and messages they hear.

11.4.3: Learning to Communicate Nonverbally

Learning Objective

Identify key facets of nonverbal communication and gain awareness of how to interpret and use them

Key Points

• Oral and written communications contain nonverbal elements that can reinforce or contradict what is being expressed verbally.
• Nonverbal communication represents two-thirds of all communication. For this reason, learning to identify and read nonverbal cues is an important communication skill.
• Nonverbal communication can enhance a spoken message through gestures, eye contact, and posture.

Key Term

nonverbal

Of communication: a form other than written or spoken words, like gestures, facial expressions, or body language.

Nonverbal communication is the process of sending and receiving wordless (mostly visual) messages between people. Oral and written communication has nonverbal elements that can reinforce or contradict what is being expressed verbally. Messages can be communicated through gestures and touch, by body language or posture, or by facial expression and eye contact. Speech also contains nonverbal elements, known as paralanguage, that include voice quality, rate, pitch, volume, and speaking style, as well prosodic features such as rhythm, intonation, and stress.

Likewise, written texts have nonverbal elements such as handwriting style, spatial arrangement of words, or the physical layout of a page. However, much of the study of nonverbal communication has focused on face-to-face interaction, in which nonverbal cues are classified into three principal areas: environmental conditions, where communication takes place; physical characteristics of the communicators; and behaviors of communicators during interaction.

Symbol table for nonverbal communication with patients

This table is an example of images that are used to communicate in place of speech.

Nonverbal communication can enhance a spoken message through body signals. Body language contains numerous elements, including physical features (both changeable and unchangeable); gestures and signals (both conscious and unconscious); and spatial relations. The listener might perceive an unintended message if the body language conveyed by the speaker does not match the verbal message. Nonverbal communication is an important component when making a first impression with a new acquaintance or business contact. Body language, stance, and voice inflection or tone can have a stronger impact than the content of an initial communication itself.

Nonverbal communication represents two-thirds of all communication. For this reason, learning to identify and read nonverbal cues is an important communication skill. While listening, try to observe the speaker’s posture, clothing, gestures, and eye contact. These convey information about the speaker as well as his or her message.

Posture

Posture or a person’s bodily stance can communicate a variety of messages. Some of the many types of posture include: slouching, towering, legs spread, jaw thrust, shoulders forward, and arm crossing. These nonverbal behaviors can indicate feelings and attitudes toward another person. Posture can be used to determine a participant’s degree of attention or involvement; the difference in status between communicators; and the level of fondness a person has for the other communicator, depending on body openness. For instance, a person who displays a forward lean or decreases a backward lean signifies positive sentiment during communication.

Clothing

Clothing is one of the most common forms of nonverbal communication. The study of clothing and other objects as a means of nonverbal communication is known as artifact or object. These studies indicate that the types of clothing an individual wears convey nonverbal clues about personality, background and financial status, and how others will respond. An individual’s clothing style can demonstrate level of confidence, cultural origin or preference, interests, age, level of authority, values and beliefs.

Gestures

Gestures may be made with the hands, arms, or body and also include movements of the head, face, and eyes, such as winking, nodding, or eye-rolling. Facial expressions, more than anything, serve as a practical means of communication. With all the various muscles that precisely control mouth, lips, eyes, nose, forehead, and jaw, human faces are estimated to be capable of more than ten thousand different expressions. This versatility makes nonverbal messages of the face extremely efficient and honest, unless they are deliberately manipulated. In addition, many emotions, including happiness, sadness, anger, fear, surprise, disgust, shame, anguish, and interest are universally recognized.

Eye Contact

When two people look at each other’s eyes at the same time, they are making eye contact. It is the primary nonverbal way of indicating engagement, interest, attention, and involvement. Studies have found that people use their eyes to indicate interest. This includes frequently recognized actions of winking and movements of the eyebrows. Disinterest is highly noticeable when individuals make little or no eye contact in a social setting. Generally speaking, the longer the established eye contact between two people, the greater the intimacy levels.

11.4.4: Delivering Constructive Feedback

Learning Objective

Employ constructive feedback in conjunction with the varying control functions available to managers in an organization

Key Points

• Positive and negative feedback can be constructive when it addresses factors directly related to performance over which someone has control.
• Constructive feedback serves as motivation for many people in the workplace.
• A performance appraisal or performance evaluation is a systematic, periodic process that assesses an individual employee’s job performance and productivity in relation to established criteria and organizational objectives.
• In human resources or industrial psychology, 360-degree feedback, also known as multi-rater feedback, multi-source feedback, or multi-source assessment, is feedback from members of an employee’s immediate work circle.

Key Terms

feedback

Critical assessment on information produced,

constructive

Carefully considered and meant to be helpful.

Critical assessments are essential to learning and performance improvement. Individuals often rely on external measures, such as exams or feedback from others, to determine strengths and weaknesses. Praise and compliments are welcome reassurance of a person’s abilities, but negative assessments can hurt unless clearly supported by observations and thoughtfully delivered. Whether positive or negative, feedback can be constructive when it addresses factors directly related to performance over which someone has control.

Knowing how to deliver constructive feedback is an important skill for a manager and leader. Constructive feedback motivates many who use it to change their behavior, study new things, or adopt new attitudes. After receiving constructive feedback, an individual decides whether and how to put it to use. Joseph Folkman, an expert in the use of the 360-degree feedback technique, comments that those who want to achieve the greatest level of success possible should learn how to accept any kind of feedback, analyze it in the most positive manner possible, and use it to influence future choices.

Feedback in Organizations

Feedback is given in organizations in a variety of ways. Some are informal, as when a colleague offers a compliment or critique after hearing a presentation or reading a report. Others feedback mechanisms are more formal and part of a process created for the explicit purpose of delivering performance assessments.

Performance Appraisal

A performance appraisal (PA) or performance evaluation is a systematic and periodic process that assesses an individual employee’s job performance and productivity in relation to certain established criteria and organizational objectives. Other aspects of employee performance are considered as well, such as organizational citizenship behavior, accomplishments, potential for future improvement, strengths and weaknesses, etc. While performance appraisals are documented in writing, usually a manager will meet to provide and discuss feedback with an employee. Using specific examples of each behavior to support each assessment is helpful in indicating what someone needs to do differently or improve.

360-Degree Feedback

In human resources, 360-degree feedback, also known as multi-rater feedback, multi-source feedback, or multi-source assessment, is feedback that comes from members of an employee’s immediate work circle. Most often, 360-degree feedback will include opinions from an employee’s subordinates, peers, and supervisor(s), as well as a self-evaluation. In some cases, it can also include feedback from external sources, such as customers and suppliers or other interested stakeholders. The 360-degree assessment may be contrasted with “upward feedback,” where managers are given feedback only by their direct reports, or with a traditional performance appraisal, in which employees are most often reviewed only by their managers.

After-Action Reviews

At the end of a project, team members benefit from reviewing how they worked together, how well they met the project objectives, and whether they achieved the planned outcome. This after-action review entails a candid analysis of work product, communication practices, individual effort, coordination and planning, and other key aspects related to the project. The goal of this form of feedback is to apply lessons learned from one project to subsequent ones. Constructive feedback in this context is best delivered by focusing on actions and outcomes rather than on blaming individuals when things did not go as planned.

11.4.5: The Impact of the Office Environment on Employee Communication

Learning Objective

Identify types and functions of physical spaces that organizations use to control information, work processes, and social interactions

Key Points

• Effective communication among team members and others requires a physical environment that facilitates interaction.
• There are three types of office spaces, each with distinct purposes and functions: work spaces, meeting spaces, and support spaces.
• Decisions about the physical environment shape information flow, work processes, and social interactions.

Key Terms

accommodate

To render fit, suitable, or correspondent; to adapt; to conform.

cubicle

A small separate part or one of the compartments of a room.

The main purpose of an office environment is to support its occupants in performing their job, preferably at minimum cost and with maximum satisfaction. In most organizations, work is accomplished by teams of people. Effective communication among team members and others requires a physical environment that facilitates interaction so individuals can coordinate activities, discuss and plan tasks, and manage interpersonal relationships effectively and efficiently. For this reason, the design of work spaces can be an important element in organizational performance.

A more open physical space can encourage casual communication since people work in close proximity with few barriers between them. Creating clear lines of sight and facilitating easy access make it easier for individuals to know who is present and available for interaction and to engage with them as needed. On the other hand, more private spaces, such as offices with doors, can create a more formal climate that distinguished between roles and status. Highly desirable corner offices occupied by an executive are an example. Individual offices can also preserve confidentiality and discretion as needed, which is especially useful for meetings between managers and their team members or when personnel matters are discussed.

Work places are typically divided into three physical areas: work spaces, meeting spaces, and support spaces. Each has it distinct function and purpose. The design of an organization’s physical environment requires a series of decisions about how the spaces will be used, by whom, and under what circumstances. Together, these choices can shape the flow of information, work processes, and interpersonal relationships.

Office space

Organizing physical space according to the functional needs of the work can improve employee communication and satisfaction.

Work Spaces

Work spaces in an office are typically used for conventional office activities such as reading, writing, and computer work. There are nine generic types of work space, each supporting different activities. These include:

• Open office – An open space for more than ten people, suitable for activities that demand frequent communication or routine activities needing relatively little concentration
• Team space – A semi-enclosed space for two to eight people, suitable for teamwork that demands frequent internal communication and a medium level of concentration
• Cubicle – A semi-enclosed space for one person, suitable for activities that demand medium concentration and medium interaction
• Private office – An enclosed space for one person, suitable for activities that are confidential, demand a lot of concentration, or include many small meetings
• Shared office – An enclosed space for two or three people, suitable for semi-concentrated work and collaborative work in small groups
• Team room – An enclosed space for four to ten people, suitable for teamwork that may be confidential and demands frequent internal communication
• Study booth – An enclosed space for one person, suitable for short-term activities that demand concentration or confidentiality
• Work lounge – A lounge-like space for two to six people, suitable for short-term activities that demand collaboration and allow impromptu interaction
• Touch down – An open space for one person, suitable for short-term activities that require little concentration and low interaction

Meeting Spaces

Meeting spaces are also an important facet to consider when improving and building work places. Following are some types of meeting spaces:

• Small meeting room – An enclosed space for two to four persons, suitable for both formal and informal interaction
• Large meeting room – An enclosed space for five to twelve people, suitable for formal interaction
• Small meeting space – An open or semi-open space for two to four persons, suitable for short, informal interaction
• Large meeting space – An open or semi-open space for five to twelve people, suitable for short, informal interaction
• Brainstorm room – An enclosed space for five to twelve people, suitable for brainstorming sessions and workshops
• Meeting point – An open area for two to four persons such as a sitting area, suitable for ad hoc, informal meetings

Support Spaces

Support spaces in an office are typically used for secondary activities such as filing documents or taking a break. There are twelve generic types of support space, each supporting different activities. These include:

• Filing space – An open or enclosed space for storing frequently used files and documents
• Storage space – An open or enclosed space for storing commonly used office supplies
• Print and copy area – An open or enclosed space with facilities for printing, scanning, and copying
• Mail area – An open or semi-open space where employees can pick up or deliver mail or packages
• Pantry area – An open or enclosed space where people can get coffee and tea as well as soft drinks and snacks
• Break area – A semi-open or enclosed space where employees can take a break from their work
• Locker area – An open or semi-open space where employees can store their personal belongings
• Library – A semi-open or enclosed space for reading and storing books, journals, and magazines
• Games room – An enclosed space where employees can interact in recreational activities (for example, video games or ping-pong) during breaks from work
• Waiting area – An open or semi-open space where visitors can be received and can wait for their appointment
• Circulation space – Space which is required for circulation on office floors, linking all major functions

11.4.6: Setting Transparency Norms

Learning Objective

Define transparency and identify how it is determined by organizations’ communication strategies and practices

Key Points

• Being transparent means operating in such a way that an organization’s actions are visible to outsiders.
• An organization’s communication norms and practices determine its degree of transparency.
• Transparency has three primary dimensions: information disclosure, clarity, and accuracy.

Key Term

transparency

Figuratively, openness and accessibility.

Transparency in organizations is the extent to which its actions are observable by outsiders. It is a consequence of regulation, social expectations, and explicit policies that establish the degree of openness to employees, shareholders, other stakeholders, and the general public. Transparency is an essential part of accountability since it allows for judgments about whether an organization is achieving its objectives and living up to its obligations and espoused values. Because transparency is the perceived quality of intentionally shared information, an organization’s communication practices and norms play an important role in shaping the visibility of its actions.

Transparency has three primary dimensions: information disclosure, clarity, and accuracy.

Information Disclosure

Information disclosure includes choices about what types of information is shared and with whom, the content of what is communicated, and the timing of the release of information. For example, managers who voluntarily share with environmental activists information related to the firm’s ecological impact are practicing disclosure. Information can be a source of power, so people may hoard it to increase their influence over others; this tactic reduces the amount of transparency. Some information is private, such as personnel matters, or commercially sensitive, like strategic business plans. Norms and policies about disclosure focus on criteria such as relevance and appropriateness to determine who should have access to what information.

Clarity

Clarity refers to how easily comprehended the information or communication is. Managers who limit the use of technical terminology, fine print, or complicated mathematical notations in their correspondence with suppliers and customers are employing clarity. Communication practices that value quality of expression, attention to the needs of different audiences, and sensitivity to cultural and other differences can help make an organization more transparent.

Accuracy

Accuracy means that available information has integrity, is truthful, and faithfully represents organizational decisions, policies, and practices. Where there is transparency, managers do not bias, embellish, or otherwise distort facts with the aim of misleading or misrepresenting reality. Organizations that value honesty, trust, and ethical practices encourage accuracy and thereby increase their transparency.

Examples of Corporate Transparency

Examples of decisions to increase corporate transparency include when a firm voluntarily shares information about their ecological impact with environmental activists; actively limiting the use of technical terminology, fine print, or complicated mathematical notations in the firm’s correspondence with suppliers and customers; and avoiding bias, embellishment, or other distortions of known facts in the firm’s communications with investors.

Wage disclosure is one particular area in which companies can practice corporate transparency. For example, in the UK, employees outside the boardroom are currently granted anonymity regarding pay levels. In 2009, UK city minister Lord Myners proposed that the pay and identity of up to 20 of the highest-paid employees at British companies be disclosed; he also called for employees’ salary ranges to be disclosed. Following these guidelines would increase transparency: the public would have access to compensation information now kept from public view. Similar proposals have become increasingly common as high executive pay levels have come under increasing scrutiny. In this case, it is unlikely that disclosure will be made a legal requirement in the UK; the hope is that companies would voluntarily accept this higher level of transparency.

11.4.7: Using Technology to Communicate

Learning Objective

Explain the role of technology in supporting communication in organizations

Key Points

• Business communication often relies on the use of technology to connect and facilitate the flow of information among individuals, groups, and organizations.
• Technology can enable real-time interaction or delayed response, that is, asynchronous with gaps in time between when a sender transmits a message and when the recipient processes it.
• Communication technologies can support unidirectional information sharing or more interactive and collaborate work.

Key Terms

Delayed Response

In communication, pertaining to the ability to respond at a later time (the opposite of real-time, such as speaking).

Unidirectional

Communication designed to provided information or data that does not require a response.

real-time

Communication occurring in that instant, necessitating immediate response and engagement (i.e. conference call, business meeting, etc.)

Business communication often relies on the use of technology to connect and facilitate the flow of information among individuals, groups, and organizations. Technologies for e-mailing, messaging, video conferencing, and document-sharing in most organizations are fully integrated into how work is conducted and how people interact.

Communication methods

Technology in communication can include e-mail, texting, and social media.

Some technologies support simultaneous, or real-time, interaction, including among individuals in different locations. In these cases, interaction is immediate and direct. Examples of this type of technology include teleconferences and web chats. Other communication tools are asynchronous, meaning messages may be transmitted by senders and processed by recipients at different times. E-mail and digital documents, such as spreadsheets and presentations, are examples of asynchronous tools. Responses from recipients may be delayed, which means the sender must wait for confirmation that the message has been interpreted as intended and resulted in the desired action. Many mobile apps used on tablets and smartphones allow for both real-time and asynchronous communication.

Communication mediated by technology can be unidirectional, flowing from a sender to one or more individuals, groups, or organizations. Unidirectional communication is typical when the sender primarily seeks to inform or influence the recipient(s). Electronic memos that are e-mailed or documents shared via computer servers are examples. Alternatively, communication can be intended as reciprocal and interactive. A collaboration tool such as Google Docs is an example.

Organizations use communication technology to support and drive their business activities. Some examples of technology used to communicate in business include:

• E-mail among employees, management, and customers
• Social media sites used to communicate with customers
• Video conferencing used to hold meetings with remote workers
• SMS (texting) among employees
• Internet marketing as way to advertise products and services to customers
• Mobile marketing strategies to advertise products to customers based on their current location
• Mobile applications such as QR codes and Shazaam offering additional information to customers about a company or service

The predominance of communication technologies in organizational life means it is vital that employees have the skills to use them. Many organizations make training available, but increasingly employers expect prospective employees to be experienced users of desktop and even mobile technologies.

11.4.8: The Importance of Sensitivity and Etiquette in Business Communication

Learning Objective

Explain the importance of identifying and considering different etiquette and cultural customs in business communication

Key Points

• Business etiquette is the code of expected professional behavior regarding manners, courtesy, and politeness.
• Etiquette is dependent on culture; what is excellent etiquette in one society may shock in another.
• A failure to understand, be sensitive to, and adjust to different etiquette expectations can impede successful communication.

Key Term

etiquette

Forms required by good breeding or prescribed by authority, to be observed in social or official life; conventional decorum; ceremonial code of polite society.

We use forms of etiquette in interactions with co-workers, business colleagues, customers, suppliers, and other types of stakeholders. These norms are typically unwritten rules learned through socialization and experience, although some organizations have explicit written rules of conduct that speak to matters of etiquette. Practicing etiquette demonstrates respect, and effective communication requires that message are sent and received in ways that are consistent with the norms of etiquette.

Business etiquette can vary significantly by country and geographic area. Etiquette is a core aspect of most cultures, which represent the values that guide how people live and interact. Differences in etiquette can create challenges for cross-cultural communication in business. What is excellent etiquette in one society may shock another. For example, conflict between expectations of etiquette can arise in meetings held during meals. In China, a person who takes the last item of food from a common plate or bowl without first offering it to others at the table may be viewed as a glutton who is insulting the host’s generosity. Traditionally, guests who do not have leftover food in front of them at the end of a meal in China have dishonored their host. Conversely, in the United States of America, guest are expected to eat all of the food given to them as a compliment to the quality of the cooking. However, there too it is considered polite to offer food from a common plate or bowl to others at the table. If both parties are aware of and sensitive to differences in etiquette, they can avoid misinterpreting behavior or giving the wrong impression.

Bowing in Japan

Bowing is an important part of etiquette in Japan.

A failure to understand, be sensitive to, and adjust to different etiquette expectations can impede successful communication. Credibility is essential in the ability to persuade, and perceived displays of disrespect can make it difficult to influence others. Etiquette reflects shared expectations of behavior, and thus it is an important basis of developing good interpersonal relationships that facilitate effective communication. The ability to use proper etiquette is an important quality of professionalism; it is therefore vital for employees to learn the norms and practices of etiquette in the organizations and cultures in which they work.

10.4: Decision Making Process

10.4.1: Identify and Define the Problem

Learning Objective

Express the importance of properly framing and defining the problem prior to pursuing a decision

Key Points

• Decision makers must first make sure that they completely understand the problem.
• It is a good idea to be able to look at a decision from multiple perspectives. This can be accomplished through selecting a group of people who will look at and define the problem from different perspectives.
• Data should be gathered on how the current problem is affecting people now. Some examples of important data to gather include efficiency levels, satisfaction levels, and output metrics.

Key Term

Output metrics

Standards or data points that showm the rate and speed of production over a certain period of time.

Decision making is a central responsibility of managers and leaders. It requires defining the issue or the problem and identifying the factors related to it. Doing so helps create a clear understanding of what needs to be decided and can influence the choice between alternatives.

An important aspect of any decision is its purpose, or objective. This is different from identifying a specific decision outcome; rather, it has to do with the motivation to make the decision in the first place. For instance, customer complaints can imply the need to change aspects of how service is delivered, so decisions must be made to address them. Factors that are not related to service delivery would not be in consideration in that decision.

There are a number of ways to define a problem, such as creating a team to tackle it and gathering relevant data by interviewing employees and customers.

Developing a Group to Define the Problem

It is a good idea to be able to approach decision definition from different perspectives. Doing so can capture dimensions of the issue that might otherwise have been overlooked. Involving two or more people can bring different information, knowledge, and experience to a decision. This can be accomplished through forming a group to consider and define the problem or issue, and then to frame the decision based on their collective ideas. Having a shared definition and understanding of a decision helps the decision-making process by creating focus for discussions and making them more efficient.

Gathering Data to Define the Decision

Most decisions require a good understanding of the current state in order to understand all implications of the potential choices. For this reason it can be valuable to consider the views of all parties that will be affected by the decision. These may include customers, employees, or suppliers. Data should be gathered on how the current problem is affecting people now. Some examples of important data to gather include efficiency levels, satisfaction levels, and output metrics. Interviews, focus groups, or other qualitative methods of data collection can be used to identify existing conditions that may be connected to the decision in question. As much information as possible should be gathered to build confidence that a decision has been accurately and appropriately formulated before additional analysis and assessment of alternatives begin.

10.4.2: Generate Alternatives

Learning Objective

Discuss methods for identifying alternatives and why doing so is an important part of decision making.

Key Points

• Decision makers should identify the many alternative choices they face before beginning to conduct analysis for a decision.
• A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes and resource costs. A decision tree can help lay out the alternatives and determine the best ones to consider.
• When dealing with information in decision analysis, there are often biases and errors in judgment, such as the fact that people pay more attention to information that is easily available.
• It is important for a decision maker to receive plenty of input from others to avoid any bias.

Key Terms

bias

An inclination towards something; predisposition, partiality, prejudice, preference, predilection.

decision tree

A visualization of a complex decision-making situation in which the possible decisions and their likely outcomes are organized in the form of a graph that resembles a tree.

Once a decision has been defined, the next step is to identify the alternatives for decision makers to select from. It is rare for there to be only one alternative; in fact, a goal should be to identify as many different alternatives as possible without making too narrow a distinction between them. The decision maker can then narrow the list based on analysis, resource limitations, or time constraints. Often, doing nothing is an alternative worthy of consideration.

Brainstorming

Brainstorming is a good technique for identifying alternatives. Making lists of possible combinations of actions can generate ideas that can be shaped into alternatives. Often this is best done with a small group of people with different perspectives, knowledge, and experience. A formal approach to capturing the results of brainstorming can help make sure options are not overlooked.

Another way to evaluate alternatives is through a decision tree.

Decision Trees

A decision tree is a decision support tool that uses a structured graphical depiction of alternatives. This method creates a visual depiction of choices so decision makers can have a clearer understanding of them. Decision trees help divide larger decisions into smaller ones and are useful for uncovering all available options.

Decision trees have a starting point and then branch out, with each branch representing a different event, action, or outcome. Resource costs, benefits, and probabilities can be recorded by each option.

Applied decision tree

Decision trees can improve investment decisions by optimizing them for maximum payoff.

Decision trees have three types of nodes at each part of the diagram:

• Decision nodes: these are the alternatives themselves and represent the point where a decision must be made.
• Change nodes: these are points where choices must be made; in their simplest form these may be represented by Yes/No or Go/No Go options.
• Conclusion or end nodes: these are the points that appear when there are no more alternatives or choices to be made, and they state the outcome of a particular decision branch.

When generating alternatives, decision makers use information gathered by defining the problem. The list of alternatives can then only be as good, complete, and accurate as the quality of that data. Overlooking factors or dimensions of an issue or problem can mean missing viable alternatives. The alternatives identified become the basis for subsequent analysis and ultimately the decision itself.

10.4.3: Evaluate Alternatives

Learning Objective

Model potential decision alternatives through utilizing pro/con analysis, influence diagrams, decision trees and Bayesian networks

Key Points

• There are a few tools available to decision makers that can be used to help quantify the potential alternatives to and outcomes of a decision. These tools include a simple pro-and-con analysis, an influence diagram, and a decision tree.
• A decision tree is used to lay out the alternatives and then assign a utility, or a relative value of importance, to a particular alternative.
• Another tool that decision makers can use to quantify a decision is an influence diagram, which is a compact graphical and mathematical representation of a decision situation.

Key Terms

Bayesian network

A probabilistic model that represents a set of random variables and their conditional dependencies (e.g., a Bayesian network could calculate the probabilities between symptoms and a disease).

decision tree

A visualization of a complex decision-making situation in which the possible decisions and their likely outcomes are organized in the form of a graph that resembles a tree.

When a decision maker has successfully and accurately defined the problem and generated alternatives, he or she can then conduct analysis useful to evaluating and assessing each. This typically involves analysis of quantitative data such as costs or revenues. Qualitative data is also used to be sure that considerations such as consistency with strategy, effects on relationships, or ethical implications are taken into account.

A first step in analysis is identifying all the sources of data needed to understand the various alternatives and their potential outcomes. Finding this data often involves research if relevant data do not exist. The results of data analysis are typically gathered, summarized, and synthesized as the basis for discussions and deliberations by decision makers.

There are a few approaches that can be used to help structure the analysis and assessment of potential decision alternatives. These range from simple tools such as lists of pros and cons to more complex models such as decision trees and influence diagrams, which can capture more variables and include more data.

A decision tree specifies alternatives visually and creates paths of subdecisions to be made or uncertainties to be considered in order to estimate the outcome of a given choice. It includes a value for each alternative, such as a financial outcome, and notes the probabilities that each outcome will occur. Decision trees sometime include the results of financial analysis such as net present value, which determines the present or current value of a stream of incoming cash flows that a project will bring in sometime in the future. One limitation to using decision trees is that they can become highly complicated as decisions become more complex or outcomes involve greater numbers of variables.

Another tool that decision makers can use to analyze alternatives is an influence diagram. An influence diagram is a compact graphical and mathematical representation of a decision situation. It groups sets of variables into things that are known and factors that are uncertain and links them to the choice to be made and the criteria for assessing it. Influence diagrams are directly applicable in group decisions because they allow incomplete sharing of information among team members to be modeled and for estimates to be made explicitly.

Influence diagram example

This is a simple example of an influence diagram used to evaluate the alternatives of a decision.

In the scenario depicted by the influence diagram above, a person is choosing between vacation alternatives. Her goal is a satisfactory vacation, which will be influenced by how good the weather is. She cannot have direct knowledge at the time of the decision what the weather will be, but she can gather information on the weather forecast or other climate patterns to help her make the choice of vacation location.

10.4.4: Determine a Course

Learning Objective

Evaluate the importance of bias and prospect theory in effectively ensuring decision makers arrive at the ideal option

Key Points

• Decision makers should use clear selection criteria to evaluate and choose among alternatives.
• Bias is inherent in making decisions, but decision makers should do their best to identify emotional and other personal factors that may affect their judgment and adjust their deliberations to take biases into account.
• Prospect theory identifies aversion to loss as a common bias that can cause people to overstate the downside of alternatives.

Key Term

bias

The human tendency to make systematic decisions in certain circumstances based on cognitive factors rather than evidence; an inclination or prejudice toward something.

Once decision alternatives have been identified and analyzed, the decision maker is ready to make a choice. To do so it is important to have a set of criteria against which to evaluate and even rank the alternatives. Selection criteria might include total cost, time to implement, risk, and the organization’s ability to successfully implement the decision. Categorizing criteria in terms of importance helps to differentiate between options that might have similar disadvantages but different advantages, or vice versa. For example, consider two alternatives that are equally risky, but one will cost more and the other will take longer to implement. In this case, the decision would depend on whether cost or time is more important. On occasion, decision makers may believe they do not have sufficient information about a particular alternative, so additional analysis may be needed.

Decision makers should do their best to minimize their biases, or preconceived ideas about which alternative is preferable, until they complete the analysis. The benefit of using data to support decisions is that when analysis is done correctly it is objective and factual, not based on emotions or subjective preferences. While it is natural to have biases based on experience or feelings, it is important for managers and leaders to recognize them and take steps to keep them from butting their judgment. People may be unable to eliminate all of their biases, especially when it comes to their tolerance for risk. It is therefore important to be explicit about assumptions and biases to the extent possible, so that people involved in making the decision are aware of them and can adjust their deliberations accordingly.

Bias and Prospect Theory

One of the best-known theories about bias in decision making is Kahneman and Tversky’s prospect theory. Prospect theory is based on the notion that people think about decisions in terms of potential gains and losses and tend to be more averse to losses than they are favorable to gains. This means that decision makers may overstate the downside of an alternative, since they have a greater fear of negative consequences. As a result, people are biased toward less risky decisions, even when the benefits of a different alternative would outweigh the risks of the chosen one. Prospect theory also suggests that people consider how others would benefit or be hurt by the outcome of their decision. This contradicts traditional economic theory, which states that individuals make decisions based only on their own well-being.

Prospect theory and risk aversion

This graph represents Kahneman and Tversky’s theory. The distance between the x-axis and the curve is smaller in the positive direction (i.e., for positive outcomes, or gains) than it is in the negative direction (i.e., for negative outcomes, or losses). This means that people’s positive value of gains is less than people’s negative value of losses. In other words, people are more sensitive to possible risk than to possible gain.

10.4.5: Implement the Course

Learning Objective

Describe the three central steps to effectively implementing a decision upon the selection of a particular perspective or course

Key Points

• Three essential actions to implementing a decision include creating an implementation plan, informing stakeholders, and executing the plan.
• It is common to adjust a plan once the work of implementing a decision begins. Throughout the implementation of the decision, there may be situations and issues that the decision maker did not consider initially.
• During the implementation phase, decision makers should be aware that they may be persuaded by pressures from stakeholders and employees to change the decision that they have made or to reconsider their decision.

Key Term

stakeholder

A person or group that affects or can be affected by an organization’s actions.

After all of the alternatives have been analyzed and one has been selected, it is time to implement the decision. Three essential actions to implementing a decision are: developing a plan, communicating with stakeholders, and executing the plan (which includes assessing outcomes and making adjustments as needed).

Developing a Plan

A decision is reached with a certain objective in mind. Once it is made, managers identify the steps needed to reach that objective. These can include listing necessary actions and activities, considering required financial and other resources, and making a schedule for completing the work. The more thought that goes into developing a plan, the less likely it is that important factors will be overlooked.

Communicating with Stakeholders

An implementation plan requires the involvement of different people, and the consequences of decisions affect various stakeholders. For these reasons it is important to have a plan for communicating important information related to the decision and its implementation. This usually involves talking with employees, but may also mean letting customers or suppliers know about the decision and any effects it may have on them.

Executing the Plan

Accomplishing the decision’s objective requires completing the steps outlined in the implementation plan. Once this work is underway, managers assess progress and may identify areas for improvement. Circumstances can change or new issues might arise that had not been thought of during the planning process. These may require additions to, or other changes in, the plan. Because most decisions are made under conditions of uncertainty, as time passes what was once unknown can become known. Where estimates were incorrect or the unexpected happens, adjustments need to be made to the implementation plans. If the new facts are significant enough, it can even require reconsideration of the decision.

During the implementation phase, decision makers should be aware that they may be persuaded by pressures from stakeholders and employees to change their decision, or to reconsider. A few of these pressures include coercive pressures and normative pressures. Coercive pressures come from the social sanctions that can be applied if one does not act in socially legitimate ways. Normative pressures arise from broad social values, and they concern what people think they should do. Both coercive and normative pressures will likely be felt by the decision maker during the implementation of the decision, especially if the decision is an unpopular one. However, the decision maker should fall back on the analyses that originally brought them to the decision and strive not to be swayed by these pressures.

10.4.6: Evaluate the Results

Learning Objective

Recognize the appraisal stage and the development of future insights as the final stage in the decision-making process

Key Points

• Evaluation is the final step of the formal decision process. Evaluating outcomes may help the decision maker learn lessons that will improve her decision-making abilities.
• Self-esteem is an important factor in evaluating results because it may lead to decision makers viewing the results of their decision with favorable bias. This can cause people to filter out or discount information that might show the decision in an unfavorable light.
• It can also be valuable to assess the process by which a decision was made to make future decisions more effective.

Key Terms

appraisal

A judgment or assessment—especially a formal one—of the value of something.

insight

An extended understanding of a subject resulting from identification of relationships and behaviors within a model, context, or scenario.

After a decision has been made and implemented it is important to assess both the outcome of the decision and the process by which the decision was reached. Doing so confirms whether the decision actually led to the desired outcomes and also provides important information that can benefit future decision making. Learning from experience is important to continuous improvement and effectiveness.

Evaluating Outcomes

The objective of evaluating outcomes is for the decision maker to develop insight into the decision. Many of the lessons developed in this stage come out of examining the implications of the decision. Insight can be obtained by referencing key business metrics such as increased revenue, lowered costs, larger market share, or greater consumer awareness. One can also consider whether a decision had the desired effect. For example, a decision to hold additional training seminars may have been intended to make it more convenient for people to learn a new technology. However, if overall attendance did not increase, then the decision may not have addressed the underlying cause of why people did not go to training events. Once the outcome of a decision is known, the results may imply a need to revise the decision and try again.

When decision outcomes are not clearly measurable or have ambiguous results—some parts good, some bad—is not uncommon for people to emphasize the favorable data and discount the negative. Maintaining self-esteem also may cause decision makers to attribute good outcomes to their actions and bad outcomes to factors outside their control. This type of bias can limit an honest assessment of what went right and what didn’t, and thus reduce what can be learned by carefully evaluating outcomes.

Appraising the Decision Process

It can also be valuable for decision makers to step back and examine the process by which a decision was made. Often they can learn lessons that will benefit future decisions. If the decision was made by a group, having a conversation with all participants is often worthwhile. Whether enough information was gathered and whether its quality was high enough are two questions that should be considered. How the decision maker dealt with uncertainty or bias can be examined in the face of the results that have transpired. If estimates were off, or it becomes clear that emotions played too large a role in making a choice, it is important to learn from those mistakes so they won’t happen again. Finally, it is important to question whether all the relevant parties contributed information and knowledge needed for the decision, and whether everyone who should have been involved was given the chance to participate.

10.5: Considering Ethics in Decision Making

10.5.1: Moral Principles in Management

Business ethics deals with the beliefs and principles that guide management decisions.

Learning Objective

Recognize the importance of ethics in the business environment, particularly how individual managers should employ these principles

Key Points

• Business ethics concerns the duties and obligations an organization has to its stakeholders, including employees, customers, suppliers, and communities.
• The corporate world has taken steps to improve ethical compliance in the workplace after major corporate scandals like WorldCom, Tyco, and Enron.
• While compliance with laws is coerced trough the threat of sanctions or litigation, ethical behavior is voluntary.
• It is the duty of all managers to see that their organization maintains ethical practices and behaviors.

Key Terms

ethics

The study of principles relating to right and wrong conduct.

moral

Of or relating to principles of right and wrong in behavior, especially for teaching right behavior.

Morality (from the Latin moralitas, meaning “manner, character, proper behavior”) is the differentiation of intentions, decisions, and actions between those that are good (or right) and those that are bad (or wrong). Ethics, also known as moral philosophy, is a branch of philosophy that involves systematizing, defending, and recommending concepts of right and wrong conduct.

Business Ethics

Business ethics (also corporate or professional ethics) is a form of applied ethics that examines the principles and moral beliefs that guide management decisions. Ethical issues include the obligations a company has to its employees, suppliers, customers and neighbors. In particular, business ethics is concerned with situations when those obligations are inconsistent with economic or strategic choices, or are in conflict with each other. Legal obligations are not the same as ethical ones; laws are enforced through the threat or imposition of punishment by a government or through civil litigation. All individuals and organizations must follow the law, but complying with ethical beliefs is voluntary, not coerced.

Business ethics applies to all aspects of business conduct by individuals and organizations as a whole. Ethical behavior is conduct that follows one’s personal beliefs or shared organizational or institutional values. When individuals take action on behalf of an organization, they represent its ethics to society. Businesses are dependent on their reputations, so it is important for them to have clear and consistent expectations regarding ethical standards to guide employee behavior. Many employees prefer to work for organizations that share their own moral beliefs. A company’s ethical practices can thus have an effect on the recruitment and retention of employees.

In recent decades there has been widespread attention to business ethics due to highly visible cases of corporate malfeasance, such as the WorldCom, Enron, and Tyco scandals. To protect their reputations, companies have begun to form more comprehensive corporate policies concerning ethics. These policies generally offer guidance to employees and state the expectations of the company. Some companies require that employees sign a contract stating that they will follow the procedures within the handbook.

To be viewed by the public as having high moral standards, many companies have created a position called the corporate ethics officer or the corporate compliance officer. This person ensures their organization has statements of ethical principals, clear guideline about acceptable and unacceptable practices, and means of reporting ethical breaches. These executives also have the specific responsibility of monitoring ethical behavior and addressing breaches.

Promoting an Ethical Business Climate

There are at least four elements that create an atmosphere conducive to ethical behavior within an organization:

1. A written code of ethics and standards
2. Ethics training for executives, managers, and employees
3. Availability for advice on ethical situations (i.e., advice lines or offices)
4. Systems for confidential reporting

It is the duty of all managers to see that their organization maintains ethical practices and behaviors. Good leaders strive to create a better and more ethical organization. Promoting an ethical climate in an organization is critical, since it is a key component in addressing many other issues facing the organization.

10.5.2: Applying the Ethical Decision Tree

Decision trees are useful analytic tools for considering the ethical dimensions of a decision.

Learning Objective

Define the concept of a decision tree as it applies to the ethical dimensions of a decision.

Key Points

• Decision trees are used to identify alternatives and estimate their likely outcomes.
• Managers can use decision-tree analysis to consider the effect of each alternative on stakeholders such as employees, customers, shareholders, and communities.
• Decision-tree analysis can help identify or uncover the potential impacts of alternatives so that a decision maker can select the option that is most consistent with her ethical and moral beliefs.

Key Terms

ethics

The study of principles relating to right and wrong conduct.

decision tree

A visualization of a complex decision-making situation in which the possible decisions and their likely outcomes are organized in the form of a graph that resembles a tree.

Ethics are moral principles that guide a person’s behavior. These morals are shaped by social norms, cultural practices, and religious influences. All decisions have an ethical or moral dimension for a simple reason—they have an effect on others. Managers and leaders need to be aware of their own ethical and moral beliefs so they can draw on them when they face decisions. They can then effectively think through an ethical issue with the same types of approaches they use for other decisions.

Decision Trees

Decision trees are graphical representations of alternatives and possible outcomes. The decisions are represented by the branches of the tree. Organizations and individuals often use decision trees as part of their decision-making process because they are a means for adding formal structure to information about a decision. Identifying the range of possibilities and their potential consequences helps clarify the decision and facilitates selection of an alternative.

Decision tree

An example of a decision tree.

Decision trees can be applied to ethical matters as well. If confronted with an ethical dilemma, creating a decision tree is a useful method for analyzing what the potential outcomes of each action would be, and ultimately, how to proceed. It is a particularly useful tool for considering stakeholders such as employees, customers, shareholders, and communities. The answers to questions about what stakeholders will be affected and what the effects will be help build the case for or against each alternative. Often there will be competing interests, or situations in which two different values are in competition. For instance, a decision to close a coal mine because coal contributes to global warming may be positive for society at large, but it imposes high costs on the employees who will lose their jobs. Decision-tree analysis can help identify or uncover the potential impacts of alternatives so that a decision maker can select the one that is most consistent with her ethical and moral beliefs.

10.5.3: Applying the Decision Tree

Decision tree analysis can be a useful tool for evaluating ethical decisions.

Learning Objective

Express decision factors in an organized and structured view, allowing for systematic, ethical, and logical decision making

Key Points

• Decision tree analysis can be a useful tool for evaluating choices involved in ethical decisions.
• Laying out each consideration, potential action, and potential outcome can be useful in deciding which alternative is most likely to be consistent with your ethical and moral beliefs and values.
• Decision tree analysis should capture both quantitative and qualitative consequences of each alternative.

Key Terms

utility

In economics, utility is a representation of preferences over some set of goods and services. Preferences have a utility representation so long as they are transitive, complete, and continuous.

decision tree

A visualization of a complex decision-making situation in which the possible decisions and their likely outcomes are organized in the form of a branched graph.

Decision tree analysis provides a visual tool to help individuals quantify and weigh options against one another when making a decision. A decision tree calculates the expected values of competing alternative. This tells the decision maker which decision has the highest utility (i.e., is the most preferred) to the decision maker.

Decision tree

This example of a decision tree shows the decision maker trying to choose where to go on vacation.

Creating a Decision Tree

A decision tree consists of 3 types of nodes:

1. Decision nodes: These are commonly represented by squares. Decision nodes are used when a decision needs to be made between at least two alternatives.
2. Chance nodes: These may be represented by circles. Chance nodes represent points on the decision tree where there is uncertainty about outcomes (so there must be at least two possible outcomes represented).
3. End nodes: These may be represented by triangles. An end node is where a decision is made and its value or utility is identified.

Applications of Decision Trees

Decision trees can be applied to ethical considerations. Consider an ethical dilemma involving a colleague. You are considering three options: report your colleague to a superior, confront the colleague yourself, or ignore the situation completely. The top box of the decision tree would state “Colleague Dilemma.”

The next three nodes would then read: “Report colleague to superiors,” “Confront colleague,” and “Ignore situation. ” Each of these nodes would then have a “Yes” arrow and a “No” arrow. For each “Yes” and “No,” you would list what the outcome would be, realizing that in some cases the nodes may need to continue to account for potential outcomes, some of which may link back to previous options. For example, a “Yes” decision arrow for “Report colleague to superiors” may result in the situation being taken care of—or, it could result in an investigation that would impact your standing within the company and with your peers. If you chose to ignore the colleague and his unethical behavior is discovered in the future, you could end up in trouble for choosing not to act earlier.

A decision tree for a tough problem allows the decision maker to visually lay out each scenario and make a detailed consideration. Decision trees therefore support the evaluation process and can help clarify often-complex ethical dilemmas.

10.6: Barriers to Decision Making

10.6.1: Cognitive Biases as a Barrier to Decision Making

Individual cognitive biases will influence decision making.

Learning Objective

Examine the complex individual influences central to the way in which decision making is pursued, most notably the cognitive, normative, and psychological perspectives

Key Points

• Decision making is shaped by individual personality and behavioral characteristics.
• Subjective biases can influence decisions by disrupting objective judgments.
• Common cognitive biases include confirmation, anchoring, halo effect, and overconfidence.

Key Term

dichotomies

Two elements, often mutually exclusive, that stand in juxtaposition to one another.

Decision making is inherently a cognitive activity, the result of thinking that may be either rational or irrational (i.e., based on assumptions not supported by evidence). Individual characteristics including personality and experience influence how people make decisions. As such, an individual’s predispositions can either be an obstacle or an enabler to the decision-making process.

From the psychological perspective, decisions are often weighed against a set of needs and augmented by individual preferences. Abraham Maslow’s work on the needs-based hierarchy is one of the best known and most influential theories on the topic of motivation—according to his theory, an individual’s most basic needs (e.g., physiological needs such as food and water; a sense of safety) must be met before an individual will strongly desire or be motivated by higher-level needs (e.g., love; self-actualization.

The Myers-Briggs Type Indicator (MBTI) is a widely used diagnostic for identifying personality characteristics. By categorizing individuals in terms of four dichotomies—thinking and feeling, extroversion and introversion, judging and perception, and sensing and intuition—the MBTI provides a map of the individual’s orientation toward decision making.

Types of Cognitive Bias

Biases in how we think can be major obstacles in any decision-making process. Biases distort and disrupt objective contemplation of an issue by introducing influences into the decision-making process that are separate from the decision itself. We are usually unaware of the biases that can affect our judgment. The most common cognitive biases are confirmation, anchoring, halo effect, and overconfidence.

1. Confirmation bias: This bias occurs when decision makers seek out evidence that confirms their previously held beliefs, while discounting or diminishing the impact of evidence in support of differing conclusions.

2. Anchoring: This is the overreliance on an initial single piece of information or experience to make subsequent judgments. Once an anchor is set, other judgments are made by adjusting away from that anchor, which can limit one’s ability to accurately interpret new, potentially relevant information.

3. Halo effect: This is an observer’s overall impression of a person, company, brand, or product, and it influences the observer’s feelings and thoughts about that entity’s overall character or properties. It is the perception, for example, that if someone does well in a certain area, then they will automatically perform well at something else regardless of whether those tasks are related.

4. Overconfidence bias: This bias occurs when a person overestimates the reliability of their judgments. This can include the certainty one feels in her own ability, performance, level of control, or chance of success.

10.6.2: Time Pressure as a Barrier to Decision Making

Time pressure forces decision makers to shift from logical processes (ideal) to intuitive processes (sub-ideal).

Learning Objective

Explain the way in which time pressure can influence decision making

Key Points

• Time pressure can distort decision-making processes and individual judgment and make them less objective and more influenced by intuition.
• Heuristics, or mental shortcuts, can deliver workable decisions under time pressure and in the absence of logical decision-making processes.
• Decision makers who feel as though they have ample time tend to arrive at more logically crafted, higher quality decisions than those who felt as though they had insufficient amounts of time, even if confronted by similar time pressure in real terms.
• While generally considered a barrier to decision making, time pressures may also have the opposite effect in terms of creating organizational motivation to render decisions and move on. In this way time pressure, real or perceived, may act as a deadline and encourage organizational dexterity.

Key Term

heuristic

A “shortcut” method of problem solving that makes assumptions based on past experiences. Examples include going by “rule of thumb,” when you apply your experience of something having happened a certain way enough times that it’s likely to continue happening that way. It is not guaranteed to be accurate every single time, but it cuts out processing time by avoiding detailed analysis of every particular situation.

Just as individual characteristics and cognitive biases can shape decision making, time pressure can also distort how we consider and choose between alternatives. Severe time constraints can make decision processes and individual judgment less objective and more influenced by intuition as more formal and rigorous approaches are ignored. All decisions are time-bound in the sense that we do not have an infinite amount of time to make a selection. Still, firm and proximate deadlines and limited resources are common causes of time pressure. Information overload is another. While considering all relevant factors is important to build support for the decision, data collection can eat up time better spent analyzing alternatives and making the decision itself.

There are some effective approaches to dealing with time pressure. Clearly defining the decision and its parameters early on can reduce ambiguity and make it easier to hone in on relevant data. Setting clear boundaries on matters such as who will participate and how long discussions will continue can similarly manage the amount of time given to a decision. In many instances, the use of heuristics can be applied to complex decisions to serve as shortcuts in conducting analysis and weighing alternatives.

Time pressure

Time pressure often forces decision makers to look for intuitive shortcuts rather than logically processing all of the required data.

There is evidence that suggests the perception of time pressure may impact decision quality. Decision makers who believe they have ample time to make a decision tend to arrive at more logically crafted decisions than those who feel as though they have an insufficient amount of time. While time pressure is generally perceived as being a barrier to effective decision making, it may also have the exact opposite effect. A limited time frame can focus mental energy and effort to bring the appropriate resources to bear on a decision more quickly and efficiently than otherwise might have been the case.

10.6.3: Group Conflict as a Barrier to Decision Making

Group dynamics, which involves the influence of social behavior, is the primary determining factor in the success of group outcomes.

Learning Objective

Recognize the value and potential drawbacks of group dynamics in making decisions

Key Points

• Interpersonal and group dynamics can make it difficult for groups to make decisions effectively.
• The presence of well-developed group cohesiveness, often achieved through healthy levels of dissent, typically results in preferable outcomes, while groupthink can lead to avoiding dissent and thus to premature consensus.
• The leader’s behavior, group norms, and how the decision-making process is structured can help prevent groupthink.

Key Terms

groupthink

The psychological phenomenon wherein a desire for conformity within a group results in them making an irrational decision; by actively suppressing dissenting viewpoints in the interest of minimizing conflict, group members reach a consensus without critically evaluating alternative viewpoints.

Synergy

Benefits resulting from combining two different groups, people, objects, or processes.

group

A number of things or persons in some relation to one another.

Delegating key decision making to groups, teams, or committees occurs often within organizations. Decisions made by groups can be better informed by broader perspectives and different sources of information and expertise than those made by an individual decision maker. Along with these advantages, however, interpersonal and group dynamics presents dilemmas that can make it more difficult for groups to make effective choices.

Group cohesion, or positive feelings between individuals and productive working relationships, contributes to effective group decision making. In cohesive groups information is more easily shared, norms of trust mean it is easier to challenge ideas, and common values help focus decisions around shared goals. Encouraging constructive disagreements and even conflict can result in more-creative ideas or more solutions that are easier to implement.

Group dynamics: the New Zealand All Blacks

Rugby, a game with fifteen players per team, is the ultimate team game. Group dynamics require all fifteen players to work together, often demanding tremendous synergy to outlast an opponent. The historic success of New Zealand’s All Blacks has been attributed not only to skill, but also to how the team achieves ideal group dynamics.

Groupthink

One of the greatest inhibitors of effective group decision making is groupthink. Groupthink is a psychological phenomenon that occurs within a group of people in which the desire for harmony or conformity results in an irrational or dysfunctional decision-making outcome. By isolating themselves from outside influences and actively suppressing dissenting viewpoints in the interest of minimizing conflict, group members reach a consensus decision without critical evaluation of alternative viewpoints.

Loyalty to the group requires individuals to avoid raising controversial issues or alternative solutions, and there is a loss of individual creativity, uniqueness, and independent thinking. The dysfunctional group dynamics of the in-group produces an illusion of invulnerability (an inflated certainty that the right decision has been made). Thus the in-group significantly overrates its own decision-making abilities and significantly underrates the abilities of its opponents (the out-group). Furthermore, groupthink can produce dehumanizing actions against the out-group.

Psychologist Irving Janus, the leading theorist of groupthink, identified ways of preventing it:

• Leaders should assign each member the role of “critical evaluator.” This allows each member to freely air objections and doubts.
• Leaders should not express an opinion when assigning a task to a group.
• Leaders should absent themselves from many of the group meetings to avoid excessively influencing the outcome.
• The organization should set up several independent groups working on the same problem.
• All effective alternatives should be examined.
• Each member should discuss the group’s ideas with trusted people outside of the group.
• The group should invite outside experts into meetings. Group members should be allowed to discuss with and question the outside experts.
• At least one group member should be assigned the role of devil’s advocate. This should be a different person for each meeting.

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10.7: Managing Group Decision Making

10.7.1: Advantages and Disadvantages of Group Decision Making

Group decision making can lead to improved outcomes, but only if a variety of conditions pertaining to group chemistry are satisfied.

Learning Objective

Assess the advantages and disadvantages that should be considered in leveraging collaborative decision-making

Key Points

• Group decisions involve two or more people, are participatory, and result in choices that are the responsibility of the group rather than any individual.
• Group decision making is subject to social influences that can provide advantages as well as disadvantages in decision outcomes.
• There are a number of potential advantages in group decision making—chief among them are shared information and more favorable outcomes achieved through synergy. Both of these advantages rely on the power of many minds undertaking a single decision.
• Disadvantages of group decision making include diffusion of responsibility and inefficiency.

Key Terms

groupthink

The psychological phenomenon wherein a desire for conformity within a group results in them making an irrational decision; by actively suppressing dissenting viewpoints in the interest of minimizing conflict, group members reach a consensus without critically evaluating alternative viewpoints.

Homogeneity

In the context of group decision making, homogeneity refers to a set of consistent and uniform ideas, prejudices, and beliefs held by all members within a group.

Group decision making (also known as collaborative decision making) is when individuals collectively make a choice from the alternatives before them. Such decisions are not attributable to any single individual, but to the group as a whole. By definition, group decisions are participatory, and often a member’s contribution is directly proportional to the degree to which a particular decision would affect him or her. Group decisions are subject to factors such as social influence, including peer pressure, and group dynamics. These social elements can affect the process by which decisions are reached and the decision outcomes themselves. A group can make decisions by consensus, in which all members come to agreement, or it may take a majority-rules approach and select the alternative favored by most members.

Advantages of Group Decision Making

Group decision making provides two advantages over decisions made by individuals: synergy and sharing of information. Synergy is the idea that the whole is greater than the sum of its parts. When a group makes a decision collectively, its judgment can be keener than that of any of its members. Through discussion, questioning, and collaboration, group members can identify more complete and robust solutions and recommendations.

The sharing of information among group members is another advantage of the group decision-making process. Group decisions take into account a broader scope of information since each group member may contribute unique information and expertise. Sharing information can increase understanding, clarify issues, and facilitate movement toward a collective decision.

Disadvantages of Group Decision Making

Diffusion of Responsibility

One possible disadvantage of group decision making is that it can create a diffusion of responsibility that results in a lack of accountability for outcomes. In a sense, if everyone is responsible for a decision, then no one is. Moreover, group decisions can make it easier for members to deny personal responsibility and blame others for bad decisions.

Lower Efficiency

Group decisions can also be less efficient than those made by an individual. Group decisions can take additional time because there is the requirement of participation, discussion, and coordination among group members. Without good facilitation and structure, meetings can get bogged down in trivial details that may matter a lot to one person but not to the others.

Groupthink

One of the greatest inhibitors of effective group decision making is groupthink. Groupthink is a psychological phenomenon that occurs within a group of people in which the desire for harmony or conformity results in an irrational or dysfunctional decision-making outcome. By isolating themselves from outside influences and actively suppressing dissenting viewpoints in the interest of minimizing conflict, group members reach a consensus decision without critical evaluation of alternative viewpoints.

Loyalty to the group requires individuals to avoid raising controversial issues or alternative solutions, and there is a loss of individual creativity, uniqueness, and independent thinking. The dysfunctional group dynamics of the in-group produces an illusion of invulnerability (an inflated certainty that the right decision has been made). Thus the in-group significantly overrates its own decision-making abilities and significantly underrates the abilities of its opponents (the out-group). Furthermore, groupthink can produce dehumanizing actions against the out-group.

10.7.2: The Manager’s Role in Group Decisions

The manager’s role in group decision making is to create a supportive context for the group.

Learning Objective

Describe the roles managers must play in supporting effective group decision-making

Key Points

• The manager’s role is to establish the conditions for an effective group-decision outcome.
• Managers can help promote effective decision making by effectively choosing group members, framing the decision, and organizing the decision process.
• Productive steps a manger can take to assist group decision making include the following: define a goal, create positive working conditions, establish expectations, provide adequate resources, and give group members ample space and latitude.

Key Term

norms

Behaviors or standards regarded as typical.

Decisions are often delegated to groups when members have the experience and information needed to arrive at the appropriate choice. Managers and leaders can take actions that support group decision making and lead to good decision outcomes. Managers can help promote effective decision making by effectively choosing group members, framing the decision, and organizing the decision process.

In order to maximize the potential of a group decision process, managers should take the following important steps:

1. Establish the team goal: By articulating the dimensions of the decision, including its importance, a manager can reduce ambiguity and help group members focus their analysis, discussions, and deliberations. A clear statement of the question to be resolved can help unify the group and create cohesion that engages members and improves collaboration.
2. Facilitate a working environment: After the decision goal is established, the working environment must allow for meaningful, honest, and open communication among group members. The manager can help establish norms about how members will interact with each other to foster constructive discourse.
3. Set clear expectations and responsibilities: By setting expectations, managers help team members understand their decision tasks and parameters (for example, deadlines). Managers might assign roles to help structure the decision process, establish a sense of accountability for parts of the group’s work, and clarify responsibilities.
4. Provide resources: Managers must be mindful that the group has adequate resources to evaluate alternatives and make its decision. Necessary adjustments may include providing additional staff, giving more time, or freeing members from other work assignments so they can fully participate in the decision-making process.
5. Get out of the way: After the manager has established the context for the group to make its decision, the best thing to do is step back and let the team perform. The most useful role at this point is that of coach, such as if the group needs help managing interpersonal relationships or if additional clarity is needed about an alternative.

Manager and employee communicating

Managers can facilitate group decision making by setting clear expectations.

10.7.3: Employee Involvement in Decision Making

Involving employees in key decisions gives managers access to unique skills and tells the employees that their contributions are valued.

Learning Objective

Distinguish the importance and inherent value of ensuring employee involvement as much as possible in the decision-making process

Key Points

• From a managerial standpoint, employee involvement is an effective way to leverage human resources and give employees a voice in something meaningful.
• Employee participation in decisions can lead to increased job satisfaction, organizational commitment, individual motivation, and job performance.
• To effectively contribute to group decisions, individuals must have relevant skills and experiences.

Key Term

motivation

An incentive or reason for doing something.

Group decisions can lead to better decision outcomes by bringing to bear a broader range of perspectives. By delegating a decision to a group, an organization can make effective use of the skills and knowledge of its employees.

Another of the benefits of group decision making in an organization is its effect on employee motivation. Providing opportunities to participate in decisions is a way to give employees a voice in something meaningful. Doing so can have positive effects on job satisfaction, organizational commitment, individual motivation, and job performance.

Employee involvement

Managers use employee involvement in key decision making not only to leverage employees’ unique skills, but also to motivate them, signaling that their impact on the company is meaningful.

Most commonly employees are involved in decisions that directly affect how their work is done. For instance, many quality-control practices include opportunities for workers to discuss and select ways to improve how they produce goods or deliver services. Self-managed teams have even broader responsibilities for decisions, such as how their work is organized, scheduled, and assigned.

To effectively participate in group decisions, employees must have the necessary skills and experience. Without relevant knowledge, participants in group decision making may not grasp the issues, know how to analyze alternatives, or be able to determine which option to choose. For instance, it would not be reasonable to expect the same level of contribution from a new recruit fresh out of college as from a more experienced employee familiar with the organization and its business priorities.

10.7.4: Techniques for Reaching a Group Consensus

Reaching consensus typically requires identifying and addressing the underlying concerns of group members.

Learning Objective

Define consensus and the varying ways in which it can be achieved in a group dynamic

Key Points

• Consensus decision making aims to reach agreement through collaboration, cooperation, inclusivity, and participation.
• Seeking consensus is not always ideal, since it can take additional time and result in suboptimal choices.
• Two approaches to making group decisions by consensus are the Quaker model and the consensus-oriented decision-making (CODM) model.

Key Term

consensus

A process of decision-making that seeks widespread agreement among group members.

Consensus decision making aims to reach agreement through collaboration, cooperation, inclusivity, and participation. Group decisions made by consensus seek resolutions that are satisfactory to all group members and meet all of their concerns. Consensus decision making is not adversarial or competitive, but rather seeks to do what is best for the group. Group members treat each other equally and solicit the input of all participants.

Making decisions by consensus is not necessarily ideal or even desirable. In an effort to please everyone, the decision may satisfy the least common denominator but not produce the best outcomes. Developing a consensus can be time consuming, and is thus more difficult to achieve when there is urgency, significant time constraints, or resource limitations.

Another way to think about consensus is as the absence of objections. In order to arrive at a group consensus, majority opinion holders must overcome any unwillingness of group members to accept a given choice. While group members may be willing to go along with a proposal, they do not actually need to favor it above another choice.

One approach to consensus building is the Quaker model. It provides a way to structure a decision process that emphasizes listening among group members. The Quaker model calls for members to refrain from speaking twice until after all group members have been heard from, the effect of which is to neutralize dominating personality types. Another key feature of the Quaker model is that it relies on a single person to act as the facilitator, or moderator, who makes sure the discussion flows according to an empathetic process. By articulating the emerging consensus, members can be clear on the decision as it emerges, and, since their views have been taken into account, will be likely to support it.

Consensus flow diagram

This diagram shows a process of steps through which consensus can be reached, by starting with concerns that are raised, moving to a discussion, then a proposal, and then further testing for consensus.

Another formal technique for consensus building comes from the consensus-oriented decision-making (CODM) model. It has seven key steps:

1. Framing the topic
2. Open discussion
3. Identifying underlying concerns
4. Collaborative proposal building
5. Choosing a direction
6. Synthesizing a final proposal
7. Closure

The CODM model outlines a process of how proposals can be collaboratively built with the full participation of all stakeholders. This model lets groups be flexible enough to make decisions when they need to, while still following a format based on the primary values of consensus decision making.

9.4: Contingency Approach

9.4.1: Leadership and Situational Context: Fiedler

Learning Objective

Assess the value and efficacy of Fred Fiedler’s leadership model

Key Points

• Situational contingency attests that different circumstances require different leadership traits.
• The Fieldler model uses the Least Preferred Co-worker (LPC) test to measure leadership traits.
• A favorable situation for a leader has three components: good relations between the leader and follower, a highly structured task, and a powerful leadership position.

Key Terms

Situational Contingency

The theory that different leaders and leadership traits are required for different situations.

Favorable Situation

Leadership contexts with good leader-member relations, high task structure, and high leader-position power.

Fred Fiedler’s model of leadership states that different types of leaders are required for different situations. This situational contingency understanding of leaderships suggests, for instance, that a leader in a strict, task-oriented workplace would have different qualities than a leader in a more open, idea-driven workplace. Fiedler subsequently enhanced his original model to increase the number of leadership traits it analyzed. This later theory, known as Cognitive Resource Theory (CRT), identifies the conditions under which leaders and group members will use their intellectual resources, skills, and knowledge effectively.

Least Preferred Co-Worker (LPC) Test

The Fiedler situational contingency model measures leadership traits with a test that provides a leadership score corresponding to the workplace where the leader would be most suited. The Least Preferred Co-worker (LPC) test asks test takers to think of someone they least prefer working with and rate that person from one to eight on a scale of various traits. For example, the taker is asked to rate the co-worker from Unfriendly (1) to Friendly (8), or Guarded (1) to Open (8). The ratings are then averaged. Generally, a higher LPC score means the person being rated is more oriented to human relations, while a lower score means the person is more oriented to tasks.

The LPC test is not actually about the co-worker; it is a profile of the test taker. Test subjects who are more oriented to human relations generally rate their least preferred co-workers higher, and the opposite is true for task-oriented test takers. The LPC test reveals how respondents react to those that with whom they do not like working, and thereby reveals leadership contexts best suited to the test takers’ personality.

Least Preferred Co-worker (LPC) test

The Least Preferred Co-worker (LPC) test reveals more about the test-taker than about the co-worker or the type of work the tester and co-worker did together.

Situational Context

The Fiedler model also analyzes the situation in which the leader functions. The situation analysis has three components:

1. Leader-member relations – the amount of respect, trust, and confidence between leaders and their followers
2. Task structure – the degree to which group tasks, roles, and processes are specified and formalized
3. Leader position power – the amount of formal authority leaders have based on their role within the group

When good leader-member relations, a highly structured task, and high leader-position power are in place, the situation is considered a “favorable situation.” Fiedler found that low-LPC leaders are more effective in extremely favorable or unfavorable situations, whereas high-LPC leaders perform best in situations with intermediate favorability. Leaders in high positions of power have the ability to distribute resources among their members, meaning they can reward and punish their followers. Leaders with low position power cannot control resources to the same extent as leaders with high position power, and so lack the same degree of situational control. For example, the CEO of a business has high position power, because she is able to increase and reduce the salary that her employees receive. On the other hand, an office worker in this same business has low position power, because although he may be the leader on a new business deal, he cannot control the situation by rewarding or disciplining colleagues with salary changes.

Criticism of the Fielder Model

Fiedler’s contingency theory has drawn criticism because it implies that the only option for a mismatch of leader orientation and unfavorable situation is to change the leader. Some have disputed the model’s validity by questioning how accurately it reflects a leader’s personality traits. Also, the contingency model does not take into account the percentage of situations that might be somewhat favorable, completely unfavorable, or even extremely favorable. For this reason, critics of the model suggest that it does not provide a complete comparison between low-LPC leaders and high-LPC leaders.

9.4.2: Leadership and Followers: Hersey and Blanchard

Learning Objective

Compare and contrast leadership style characteristics with the follower maturity concepts as defined by Hersey and Blanchard

Key Points

• The ideal leadership style varies based on what is required of a group and that group’s level of development. The Hersey and Blanchard model measures this by categorizing leadership style and group (follower) maturity.
• Leadership styles are a mix of task behavior and relationship behavior. There are four combinations of high and low task and relationship behaviors that imply different leadership roles.
• Group maturity describes how confident group members are in the group’s ability to complete its tasks.

Key Terms

Relationship Behavior

The style of leadership that is concerned with guiding how people interact, instead of the mechanics of how they complete the task.

Situational Leadership

The theory that different leadership styles are required for different contexts.

Task Behavior

The style of leadership that is concerned with instructing followers what actions to take.

Paul Hersey and Ken Blanchard introduced their theory of situational leadership in the 1969 book Management of Organizational Behavior. Situational leadership states that there is no single, ideal approach to leadership because different types of leadership are required in different contexts. The Hersey and Blanchard model explains effective leadership in terms of two variables: leadership style and the maturity of the follower(s).

Task Behavior and Relationship Behavior

For Hersey and Blanchard, leadership style is determined by the mix of task behavior and relationship behavior that the leader shows. Task behavior concerns the actions required of followers and how they should be conducted. Relationship behavior concerns how people interact together to achieve a goal. The various combinations of high and low task and relationship behaviors suggest four leadership roles:

1. S1 – Telling: The leader’s role is to direct the actions of the followers. The leader instructs the followers on how, what, where, and when to do a certain task. This is primarily task behavior.
2. S2 – Selling: The leader is still primarily concerned with directing action but now accepts communication from followers. This communication allows the followers to feel connected to the task and buy into the mission. S2 leading is still primarily task behavior, but now it includes some relationship behavior.
3. S3 – Participating: This role is similar to S2, except now the leader welcomes shared decision-making. Participating leadership shifts the balance toward relationship behavior and away from task behavior.
4. S4 – Delegating: The leader simply ensures that progress is being made. Decisions involve a lot of input from the followers, and the process and responsibility now lie with followers. S4 is primarily relationship behavior.

Maturity

The other fundamental concept in the Hersey and Blanchard model is maturity of the group. Group maturity describes how confident group members are in the group’s ability to complete its tasks. This concept, too, is broken into four categories:

Maturity levels

In Hersey and Blanchard’s model, group maturity is divided into four distinct categories based on how able and willing the group is to complete the job.

1. M1: The group does not have the skills to do the job, and is unwilling or unable to take responsibility. This is a very low maturity level.
2. M2: The group is willing to work on the job but not yet able to accept responsibility. Imagine a group of volunteers working on a house for Habitat for Humanity: the volunteers are willing to perform the work, but probably not capable of building a house on their own.
3. M3: The group has experience but is not confident enough or willing to take responsibility. The main difference between M2 and M3 is that the M3 group has the skills to work effectively on the job.
4. M4: The group is willing and able to work on the job. Group members have all of the skills, confidence, and enthusiasm necessary to take ownership of the task. This is a very high level of maturity.

Because maturity level varies based on the group and the task (for example, professional football players are an M4 group on the football field, but an M1 group if asked to play baseball), the leadership style must adapt based on the situation.

Effective leadership varies not only with the person or group that is being influenced but also depending on the task, job, or function that needs to be accomplished. The Hersey and Blanchard model encourages leaders to be flexible and find the right style for the task and the group maturity level. The most successful leaders are those who adapt their leadership style to the maturity of the group they are attempting to lead or influence and to that group’s purpose.

9.4.3: Leadership and Task/Follower Characteristics: House

Learning Objective

Identify the leadership and task/follower characteristics identified by Robert House in the Path-Goal theory (1971)

Key Points

• In the Path-Goal model as defined by House, the role of the leader is to help followers define personal goals, understand organizational goals, and find a path to reach both.
• House defined four leadership styles: directive, achievement-oriented, participative, and supportive.
• Outstanding Leadership Theory is an extension of the Path-Goal model that adds leadership behaviors required to channel follower motivations and goals toward the leader’s vision.

Key Terms

Outstanding Leadership Theory

A model that defines ten traits that exceptional leaders possess; an expansion of the Path-Goal model.

Path-Goal theory

A leadership model outlining the role of the leader as helping followers define personal and organizational goals and find a path to reach those goals.

In 1971, Robert House introduced his version of a contingent theory of leadership known as the Path-Goal theory. According to House’s theory, leaders’ behavior is contingent upon the satisfaction, motivation, and performance of their subordinates. House argued that the goal of the leader is to help followers identify their personal goals as well understand the organization’s goals and find the path that will best help them achieve both. Because individual motivations and goals differ, leaders must modify their approach to fit the situation.

Leadership Styles

House defined four different leadership styles and noted that good leaders switch fluidly between them as the situation demands. He believed that leadership styles do not define types of leaders as much as they do types of behaviors. House’s leadership styles include:

1. Directive, path-goal clarifying leader: The leader clearly defines what is expected of followers and tells them how to perform their tasks. The theory argues that this behavior has the most positive effect when the subordinates’ role and task demands are ambiguous and intrinsically satisfying.
2. Achievement-oriented leader: The leader sets challenging goals for followers, expects them to perform at their highest level, and shows confidence in their ability to meet this expectation. Occupations in which the achievement motive was most predominant were technical jobs, salespersons, scientists, engineers, and entrepreneurs.
3. Participative leader: The leader seeks to collaborate with followers and involve them in the decision-making process. This behavior is dominant when subordinates are highly personally involved in their work.
4. Supportive leader: The main role of the leader is to be responsive to the emotional and psychological needs of followers. This behavior is especially needed in situations in which tasks or relationships are psychologically or physically distressing.

The Path-Goal model emphasizes the importance of the leader’s ability to interpret follower’s needs accurately and to respond flexibly to the requirements of a situation.

Outstanding Leadership Theory (OLT)

In 1994, House published Organizational Behavior: The State of the Science with Philip Podsakoff. House and Podsakoff attempted to summarize the behaviors and approaches of “outstanding leaders” that they obtained from some more modern theories and research findings. Using the Path-Goal model as a framework, their Outstanding Leadership Theory (OLT) expanded the list of leadership behaviors required to channel follower’s motivations and goals more effectively toward the leader’s vision:

• Vision: Leaders are able to communicate a vision that meshes with the values of their followers.
• Passion and self-sacrifice: Leaders believe fully in their vision and are willing to make sacrifices in order to achieve it.
• Confidence, determination, and persistence: Leaders are confident their vision is correct and take whatever action is necessary to reach it.
• Image-building: Leaders are cognizant of how they are perceived by their followers. They strive to ensure followers view them in a positive light.
• Role-modeling: Leaders seek to model qualities such as credibility and trustworthiness that their followers would seek to emulate.
• External representation: Leaders are spokespersons for their organizations (for example, Steve Jobs).
• Expectations of and confidence in followers: Leaders trust that their followers can succeed and expect them to do so.
• Selective motive-arousal: Leaders are able to hone in on specific motives in followers and use them to push their followers to reach a goal.
• Frame alignment: Leaders align certain interests, values, actions, etc. between leadership and followers to inspire positive action.
• Inspirational communication: Leaders are able to inspire followers to act using verbal and non-verbal communication.

9.4.4: Leadership and Decision Making: The Vroom-Yetton-Jago Model

Learning Objective

Apply the Vroom-Jago decision-tree model to guide leaders in a decision-making situation

Key Points

• Different tasks and situations require leaders to make different types of decisions.
• There are five different approaches to making group decisions according to the degree and type of follower participation.
• The Vroom-Yetton-Jago model employs a decision tree for determining the right mode of decision making under different conditions.

Key Terms

Contingency Approach

A school of thought on leadership that proposes that there is no single ideal leader or leadership style. Also known as situational leadership.

decision tree

A visualization of a complex decision-making situation in which the possible choices and their likely outcomes are organized in the form of a graph.

autocratic 

Conducted alone and with sole responsibility.

The Vroom-Yetton-Jago model is a contingency approach to group decision making that is designed specifically to help leaders select the best approach to making decisions. The model identifies different ways a decision can be made by considering the degree of follower participation. It proposes a method for leaders to select the right approach to making a decision in a given set of circumstances.

Decision Types

The Vroom-Yetton-Jago model defines five different decision approaches that a leader can use. In order of participation from least to most, these are:

1. AI – Autocratic Type 1: Decisions are made completely by the leader. Leaders make the decision on their own with whatever information is available.
2. AII – Autocratic Type 2: The decision is still made by the leader alone, but the leader collects information from the followers. Followers play no other role in the decision-making process.
3. CI – Consultative Type 1: The leader seeks input from select followers individually based on their relevant knowledge. Followers do not meet each other, and the leader’s decision may or may not reflect followers’ influence.
4. CII – Consultative Type 2: Similar to CI, except the leader shares the problem with relevant followers as a group and seeks their ideas and suggestions. The followers are involved in the decision, but the leader still makes the decision.
5. GII – Group-based Type 2: The entire group works through the problem with the leader. A decision is made by the followers in collaboration with the leader. In a GII decision, leaders are not at liberty to make a decision on their own.

Decision Trees

The Vroom-Yetton-Jago model also provides guidance for leaders trying to determine which approach to decision making to use (AI through GII). The model uses a decision-tree technique to diagnose aspects of the situation methodically. This technique involves answering a series of yes or no questions and following the yes path to the recommended type of decision-making approach.

Decision tree

This is an example of a decision tree. One decition (go on vacation) leads to further decisions (whether to go to Europe, visit family, or go camping), all of which lead to another tier of decisions. The Vroom-Yetton-Jago model utilizes decision trees to determine the best leadership style for a given situation.

1. Is there a quality requirement? Is the nature of the solution critical? Are there technical or rational grounds for selecting among possible solutions?
2. Do I have sufficient information to make a high-quality decision?
3. Is the problem structured? Are the alternative courses of action and methods for their evaluation known?
4. Is acceptance of the decision by subordinates critical to its implementation?
5. If I were to make the decision by myself, is it reasonably certain that it would be accepted by my subordinates?
6. Do my subordinates share the organizational goals to be met by solving this problem?
7. Is conflict among subordinates likely in obtaining the preferred solution?

By answering the questions honestly, the decision tree provides the leader with the preferred decision style for the given situation.

9.5: Types of Leaders

9.5.1: Transactional Versus Transformational Leaders

Transactional leaders are concerned about the status quo, while transformational leaders are more change-oriented.

Learning Objective

Differentiate between transactional leaders and transformational leaders in a full-range approach, particularly from a behavioral perspective

Key Points

• Transactional leadership works within set established goals and organizational boundaries, while a transformational approach challenges the status quo and is more future-oriented.
• Transactional leadership emphasizes organization, performance evaluation and rewards, and is task- and outcome-oriented.
• Transformational leadership focuses on motivating and engaging followers with a vision of the future.

Key Term

Buy-in

In management and decision making, the commitment of interested or affected parties (often called stakeholders) to agree to support a decision, often by having been involved in its formulation.

Leadership can be described as transactional or transformational. Transactional leaders focuses on the role of supervision, organization, and group performance. They are concerned about the status quo and day-to-day progress toward goals. Transformational leaders work to enhance the motivation and engagement of followers by directing their behavior toward a shared vision. While transactional leadership operates within existing boundaries of processes, structures, and goals, transformational leadership challenges the current state and is change-oriented.

Transactional Leadership

Transactional leadership promotes compliance with existing organizational goals and performance expectations through supervision and the use of rewards and punishments. Transactional leaders are task- and outcome-oriented. Especially effective under strict time and resource constraints and in highly-specified projects, this approach adheres to the status quo and employs a form of management that pays close attention to how employees perform their tasks.

Transformational Leadership

Transformational leadership focuses on increasing employee motivation and engagement and attempts to link employees’ sense of self with organizational values. This leadership style emphasizes leading by example, so followers can identify with the leader’s vision and values. A transformational approach focuses on individual strengths and weaknesses of employees and on enhancing their capabilities and their commitment to organizational goals, often by seeking their buy-in for decisions.

Comparing Leadership Types

Transactional and transformational leadership exhibit five key differences:

1. Transactional leadership reacts to problems as they arise, whereas transformational leadership is more likely to address issues before they become problematic.
2. Transactional leaders work within existing an organizational culture, while transformational leaders emphasize new ideas and thereby “transform” organizational culture.
3. Transactional leaders reward and punish in traditional ways according to organizational standards; transformational leaders attempt to achieve positive results from employees by keeping them invested in projects, leading to an internal, high-order reward system.
4. Transactional leaders appeal to the self-interest of employees who seek out rewards for themselves, in contrast to transformational leaders, who appeal to group interests and notions of organizational success.
5. Transactional leadership is more akin to the common notions of management, whereas transformational leadership adheres more closely to what is colloquially referred to as leadership.

9.5.2: Key Behaviors of Transactional Leaders

Transactional leaders focus on performance, promote success with rewards and punishments, and maintain compliance with organizational norms.

Learning Objective

Identify the different behaviors attributed to transactional leaders and how they can motivate an organization

Key Points

• Transactional leaders focus on managing and supervising their employees and on group performance. They monitor their employees’ work carefully to assess any deviation from expected standards.
• Transactional leaders promote success by doling out both rewards and punishments contingent on performance.
• Transactional leaders work within existing organizational structures and shape their work according to the current organizational culture.

Key Term

Maslow’s Hierarchy of Needs

A psychological theory, proposed by Abraham Maslow in the 1943 paper “A Theory of Human Motivation,” which depicts lower- and higher-level human needs in the form of a pyramid.

Transactional leaders focus on managing and supervising their employees and on facilitating group performance. The role of a transactional leader is primarily passive, in that it sets policy and assessment criteria and then intervenes only in the event of performance problems or needs for exceptions. Transactional leaders seek to maintain compliance within existing goals and expectations and the current organizational culture. They are extrinsic motivators who encourage success through the use of rewards and punishment.

Benchmarking Measures Performance

Results are the paramount concern to a transactional leader. Performance ratings can be used to measure results.

Transactional leaders are expected to do the following:

• Set goals and provide explicit guidance regarding what they expect from organizational members and how they will be rewarded for their efforts and commitment
• Provide constructive feedback on performance
• Focus on increasing the efficiency of established routines and procedures and show concern for following existing rules rather than making changes
• Establish and standardize practices that will help the organization become efficient and productive
• Respond to deviations from expected outcomes and identify corrective actions to improve performance

Psychologist Abraham Maslow characterized people’s motivating factors in terms of needs. Maslow’s Hierarchy of Needs describes levels of needs ranging from the most essential, such as physiological (e.g., food and sleep) and safety, to higher levels of esteem and self-actualization. Transactional leadership satisfies lower-level needs but addresses those at a high level only to a limited degree. As such, transactional leaders’ behavior appeals to only a portion of followers’ motivating factors.

Transactional leadership can be very effective in the right settings. Coaches of sports teams are a good example of appropriate transactional leadership. The rules for a sports team allow for little flexibility, and adherence to organizational norms is key; even so, effective coaches can motivate their team members to play and win, even at risk to themselves.

9.5.3: Key Behaviors of Transformational Leaders

Transformational leaders exhibit individualized consideration, intellectual stimulation, inspirational motivation, and idealized influence.

Learning Objective

Explain the varying approaches and behaviors that define transformational leadership

Key Points

• Transformational leaders show individualized consideration to followers by paying attention to and meeting the needs of followers.
• Transformational leaders stimulate ideas and creativity from followers by creating a safe environment to challenge the status quo.
• Transformational leaders have a vision that inspires and motivates followers to achieve important goals.
• Transformational leaders serve as role models for their followers, allow them to identify with a shared organizational vision, and provide a sense of meaning and achievement.

Key Term

Transformational Leadership

An approach to leading that enhances the motivation, morale, and performance of followers through a variety of mechanisms.

Transformational leaders challenge followers with an attractive vision and tie that vision to a strategy for its achievement. They engage and motivate followers to identify with the organization’s goals and values. Transformational leadership comprises four types of behavior:

Leading the team

Transformational leaders inspire their employees to do more.

• Individualized consideration or compassionate leadership
• Intellectual stimulation
• Inspirational motivation
• Idealized influence or charismatic leadership

Individualized Consideration

Individualized consideration is the degree to which the leader attends to each follower’s needs, acts as a mentor or coach to the follower, and listens to the follower’s concerns. This behavior can include the following actions:

• Discussing and empathizing with the needs of individual employees
• Making interpersonal connections with employees
• Showing genuine compassion
• Encouraging ongoing professional development and personal growth of employees

Intellectual Stimulation

Transformational leaders encourage followers to be innovative and creative. Intellectual stimulation springs from leaders who establish safe conditions for experimentation and sharing ideas. They tackle old problems in a novel fashion and inspire employees to think about their conventional methods critically and share new ideas. This type of behavior includes:

• Encouraging employees’ creativity
• Challenging the status quo
• Aiming for consistent innovation
• Empowering employees to disagree with leadership
• Risk-taking when appropriate to achieve goals

Inspirational Motivation

Leaders with an inspiring vision challenge followers to leave their comfort zones, communicate optimism about future goals, and provide meaning for the task at hand. Purpose and meaning provide the energy that drives a group forward. The visionary aspects of leadership are supported by communication skills that make the vision understandable, precise, powerful, and engaging. Followers are willing to invest more effort in their tasks; they are encouraged and optimistic about the future and believe in their abilities. Behaviors that demonstrate inspirational motivation include:

• Inspiring employees to improve their outcomes
• Explaining how the organization will change over time
• Fostering a strong sense of purpose among employees
• Linking individual employee and organizational goals
• Aiding employees to succeed to an even greater extent than they expect

Idealized Influence

Transformational leaders act as role models for their followers. Transformational leaders must embody the values that the followers should be learning and internalizing. The foundation of transformational leadership is the promotion of consistent vision and values. Transformational leaders guide followers by providing them with a sense of meaning and challenge. They foster the spirit of teamwork and commitment in the following ways:

• Promoting a broad, inclusive vision
• Leading by example
• Showing strong commitment to goals
• Creating trust and confidence in employees
• Representing organizational goals, culture, and mission

9.5.4: A Blended Approach to Leadership

The full-range leadership theory blends the features of transactional and transformational leadership into one comprehensive approach.

Learning Objective

Assess the intrinsic value of blending transactional leadership behaviors with transformational leadership behaviors

Key Points

• Transactional and transformational leadership are not mutually exclusive, and leaders often demonstrate traits associated with both approaches.
• The Multifactor Leadership Questionnaire is used in diagnosing leadership styles and for developing leadership.
• Leaders use elements of transformational and transactional leadership as the situation calls for them.

Key Terms

Transactional Leadership

A theory of leading that focuses on the role of supervision, organization, and group performance; leader promotes compliance through rewards and punishments. Also known as managerial leadership.

Transformational Leadership

A theory of leading that enhances the motivation, morale, and performance of followers through a variety of mechanisms.

The full-range theory of leadership seeks to blend the best aspects of transactional and transformational leadership into one comprehensive approach. Transactional leadership focuses on exchanges between leaders and followers. Transformational leadership deals with how leaders help followers go beyond individual interests to pursue a shared vision. These two approaches are neither mutually exclusive, nor do leaders necessarily exhibit only one or the other set of behaviors. Depending on the objectives and the situation, a leader may move from using one approach to the other as needed.

Management researcher Bernard Bass developed the Multifactor Leadership Questionnaire (MLQ), consisting of 36 items that reflect the leadership aspects associated with both approaches. The MLQ also includes several characteristics of a more passive leadership approach known as laissez-faire. Respondents are asked to think about a leader they work with and to rate how frequently the individual exhibits the leadership behaviors. The MLQ is used to help leaders discover how their followers perceive their behaviors, so they can develop their leadership abilities. The questionnaire is most effective with eight to twelve respondents, as this feedback gives leaders a broad set of perspectives from the people who interact with them.

9.6: Other Leadership Perspectives

9.6.1: Emotional Leadership

Emotional leadership is a process that leaders use to influence their followers to pursue a common goal.

Key Points

• As leadership is all about influencing people to achieve a common goal, an “emotional” approach can be a very important step of the process.
• Leaders in a positive mood can affect their group in a positive way, and vice versa. Charismatic leaders can transmit their emotions and thereby influence followers through the mechanism of “emotional contagion”.
• Group affective tone refers to mood at the group level of analysis. Groups with leaders in a positive mood have a more positive affective tone than groups with leaders in a negative mood. Group processes like coordination, effort expenditure, and task strategy also affect followers.
• Public expressions of mood influence how group members think and act relative to other group members. Group members respond to those signals cognitively and behaviorally in ways that are reflected in the group processes.
• Strong emotional leadership depends on having high levels of emotional intelligence (EI).

Key Terms

Emotional Leadership

Emotional leadership is a process that leaders use to influence their followers in a common goal.

emotional intelligence

the ability, capacity, or skill to perceive, assess, and manage the emotions of oneself, of others, and of groups

Leadership is a process of motivating people and mobilizing resources to accomplish common goals. Leaders direct the path to achieve the goal and lead the group to accomplish objectives along the way. The leader may or may not have formal authority. According to the trait theory of leadership, some traits play a vital role in creating leaders, such as intelligence, adjustment, extroversion, conscientiousness, openness to experience, and general self-efficacy. One key aspect of contemporary leadership theory points to emotional leadership as a possible approach to accomplishing organizational aims.

Defining Emotional Leadership

As leadership is all about influencing people to achieve a common goal, an “emotional” approach can be a very important step of the process. A leader’s mood or emotions have an effect on the group in three major ways:

1. Leaders can influence followers through the mechanism of “emotional contagion.” Those in an optimistic mood can effect their group in a positive way by instilling a positive outlook. For example, a charismatic leader can inspire feelings of confidence in a group’s ability to achieve challenging goals.
2. Group affective tone refers to the collective mood of individuals. Groups with leaders in a positive mood have more positive feelings toward each other than groups with leaders who convey the opposite. The perceived efficacy of group processes such as coordination, collaborative effort, and task strategy can also effect the emotions of followers.
3. Public expressions of mood affect how group members think and act in relation to other group members. For example, demonstrating positive emotions such as happiness or satisfaction can signal that leaders acknowledge solid progress toward goals. Those signals influence how followers think about their work, which can benefit their work together.

Emotional Intelligence

Strong emotional leadership depends on having high levels of emotional intelligence (EI). EI is the ability to identify, assess, and control the emotions of oneself, of others, and of groups. The two most prominent approaches to understanding EI are the ability and trait EI models.

The EI ability model views emotions as useful sources of information that help a person make sense of and navigate the social environment. The model proposes that individuals vary in their ability to process information of an emotional nature and in their ability to connect those emotions to how they think. There are four key emotional skills—perceiving, using, understanding, and managing:

1. Perceiving emotions – The ability to detect and decipher emotions in faces, pictures, voices, and cultural artifacts—including one’s own emotions. Perceiving emotions represents a basic aspect of emotional intelligence, as it makes all other processing of emotional information possible.
2. Using emotions – The ability to harness emotions to facilitate various cognitive activities, such as thinking and problem-solving. Emotionally intelligent people can capitalize fully upon their changing moods according to the task at hand.
3. Understanding emotions – The ability to comprehend emotional language and to appreciate complicated relationships among emotions. For example, understanding emotions encompasses the ability to be sensitive to slight variations between emotions, as well as the ability to recognize and describe how emotions evolve over time.
4. Managing emotions – The ability to regulate emotions in both ourselves and in others. The emotionally intelligent person can harness emotions—even negative ones—and manage them to achieve intended goals.

Because the EI ability model focuses on behaviors that can be learned, it is used as the basis of leadership development activities.

The EI trait model focuses not on skills but on personality characteristics and behavioral dispositions such as empathy, consideration, and self-awareness. Trait EI refers to individuals’ self-perceptions of their emotional abilities. It is measured by looking at degrees of emotional well-being, self-control, emotionalism, and sociability. EI traits can be challenging to assess accurately because they rely on self-reporting, rather than observations of actual behaviors. Personality traits are generally believed to be resistant to significant change, so the EI trait model is used to help people better manage their emotional abilities within the constraints of existing behavioral tendencies.

President Barack Obama

Many observers identify President Obama as a good example of an emotional leader.

9.6.2: Interactive Leadership

Interactive leadership involves leaders’ engaging followers to increase their understanding of tasks and goals.

Learning Objective

Explain the importance of interactive leadership in generating motivation and commitment to shared objectives

Key Points

• Interactive leaders engage followers in understanding goals and tasks to contribute more effectively to achieving them.
• Reaching out to employees and helping them understand different aspects of the organization serve to engage them in the organization’s goals.
• Interactive leaders demonstrate their willingness to engage others in a variety of ways, including group decision making, building trust through openness and transparency, and being visible and accessible to followers.

Key Term

Interactive Leadership

Style of leading that engages employees in understanding tasks and goals so they can be effective contributors to achieving them.

Effective leadership requires communicating and engaging with followers. The interactive style of leadership makes it a priority to inform followers about important matters related to their goals and tasks and to clarify understanding. Interactive leaders are proactive in seeking information and opinions from followers. Reaching out to employees in this way helps build their commitment to achieving team and organizational goals.

Interactive leaders take the opportunity to meet with followers to explain their vision and persuade them of its value. This encounter facilitates behavior change; the better people understand what is expected of them, the more they can modify how they act. While interactive leaders may make use of technology to share information, they also seek the richer exchanges that face-to-face communication allows.

Examples of Interactive Leadership

Interactive leaders engage followers in a variety of ways. When making group decisions they may solicit information, perceptions, and even recommendations from team members. To underscore a commitment to openness and to build trust, an interactive leader freely shares information rather than keeping it as a basis of power over others.

Interactive leaders value individual contributions and maintain relationships that foster mutual respect. They also make themselves visible and accessible to followers; some maintain an “open-door” policy to signal that they are open to dialogue and hearing from others. In this way, interactive leaders are role models who exhibit the quality of reciprocal interactions they seek with others.

Interactive leadership in action

An interactive leader shares information and answers questions to clarify goals and tasks.

9.6.3: Moral Leadership

Ethical or moral leadership demonstrates responsibility for doing what is right.

Learning Objective

Apply ethical standards to leadership perspectives, explaining the relevance of integrity and responsibility to leadership

Key Points

• Ethical or moral leadership involves leading in a manner that respects the rights and dignity of others.
• The duties of leaders also include the responsibility to ensure standards of moral and ethical conduct.
• An effective leader influences a subordinate’s attitude and values. Therefore, a moral leader will stimulate a moral influence.
• The best leaders make known their values and ethics and reflect them in their leadership styles and actions.

Key Term

moral

Of or relating to principles of right and wrong in behavior, especially for teaching right behavior.

Moral or ethical leadership involves the commitment to doing what is right according to societal and cultural beliefs and values about acceptable behavior. Ethical leaders distinguish themselves by making decisions in the service of long-term benefits that may be inconvenient, unpopular, and even unprofitable in the short-term. Moral leaders have a clear understanding of their own values and hold themselves accountable for them. Leaders who are ethical demonstrate a level of integrity that emphasizes their trustworthiness, and this trust enables followers to accept the leader’s vision.

Moral leadership means making decisions that respect the rights and dignity of others. Moral leaders consider the viewpoints and needs of all who have an interest in a decision’s outcomes, rather than simply the most powerful. In this way, moral leaders use their own power to convince others of the rightness of their choices.

Nelson Mandela, a respected moral leader

Nelson Mandela, the President of South Africa from 1994 to 1999, is an example of moral leadership. Mandela fought to end apartheid and establish equality in his country.

Moral leadership is important for protecting an organization’s reputation. The ethics leaders exhibit reflects on their organizations, as well on themselves. Acting ethically preserves an organization’s legitimacy as it uses societal resources to achieve its aims.

Moral leadership goes beyond doing what is legal. Laws establish clear boundaries of what is acceptable, but ethics often involves more ambiguous questions. These dilemmas are where the judgment of a leader comes into play. The personal character of leaders influences their ability and willingness to act on moral principles. Moral leaders gain the respect of followers, who are then more likely to identify with their leaders and the goals they set.

Moral leaders also play an important role in communicating an organization’s values. They do this as role models of ethical behavior and in how they speak about the moral dimension of their decisions and actions. In this way, moral leaders take responsibility for the moral climate in their organizations and help others understand, share, and act in accordance with those values.

9.6.4: Servant Leadership

Servant leadership involves feeling responsible for the world and actively contributing to the well-being of people and communities.

Learning Objective

Define servant leadership using the behaviors and characteristics described by Larry C. Spears

Key Points

• Servant leadership is apparent in leaders who feel a responsibility for the well-being of others and their communities.
• A servant leader looks at what people need, helps them solve problems, and promotes the personal development of others.
• Larry C. Spears identified ten characteristics central to servant leaders: listening, empathy, healing, awareness, persuasion, conceptualization, foresight, stewardship, commitment to the personal growth of people, and building communities.

Key Terms

Larry C. Spears

Served as president and CEO of the Robert K. Greenleaf Center for Servant Leadership.

Servant Leadership

An approach to leading in which leaders take responsibility for contributing to the well-being of people and community.

Servant leadership involves taking responsibility for actively contributing to the well-being of people and communities. It begins with a feeling of wanting to work for the benefit of others. A servant leader regards people’s needs and identifies ways to help them to solve problems and promote personal development. Servant leaders focus on the well-being of others and on helping them improve their circumstances.

Characteristics of Servant Leadership

Larry C. Spears identified ten characteristics that are central to servant leadership:

1. Listening: A servant leader solicits information and engages in dialogue with followers to better understand their needs.
2. Empathy: Servant leaders identify with and show concern for the needs of followers. In this way they model respect.
3. Healing: A servant leader is sensitive to and supports the emotional health of others.
4. Awareness: Servant leaders exhibits self-knowledge of their own values, emotions, strengths, and weaknesses.
5. Persuasion: Servant leaders do not take advantage of their power and status by coercing compliance; they try to influence others through reason.
6. Conceptualization: A servant leader thinks beyond day-to-day realities to identify future possibilities.
7. Foresight: A servant leader understands intellectually as well as through intuition how the past, present, and future are connected and uses that knowledge to identify likely outcomes.
8. Stewardship: Servant leaders are mindful that they hold an organization’s resource in trust for the greater good.
9. Commitment to the growth of people: A servant leader is responsible for nurturing others and for their learning and development.
10. Building community: A servant leader builds a sense of unity and cohesion among individuals so they can work together for common goals.

9.6.5: Shared Leadership

Shared leadership means that leadership responsibilities are distributed within a team and that members influence each other.

Learning Objective

Describe shared leadership and the conditions needed for its success

Key Points

• Shared leadership occurs when two or more individuals in a group share responsibility for directing it toward its goals.
• Shared leadership requires team members be willing to extend their feedback to the team in a way that aims to influence and motivate the direction of the group.
• The team must overall be disposed to accept and rely on feedback from other team members.

Key Term

Shared Leadership

Style of leading in which responsibilities are distributed within a team or organization, and people within that team or organization lead each other.

Unlike traditional notions of leadership that focus on the actions of an individual, shared leadership refers to responsibilities shared by members of a group. Rather than having a single designated leader, two or more members of a team with shared leadership influence the others and help drive the team’s performance toward its goals.

While by definition a team’s members share responsibility for group outcomes, shared leadership means they also hold each other accountable for setting the team’s goals and maintaining its direction. Shared leadership can involve all team members simultaneously or distribute leadership responsibilities sequentially over the group’s duration. Leadership roles may be assigned based on expertise and experience.

Requirements of Shared Leadership

Research reveals that for shared leadership to merge and succeed, two conditions must be met:

1. Team members must be willing to extend their feedback to the team in a way that aims to influence and motivate the direction of the group.
2. Team members as a group must be disposed to accept and rely on the feedback of each other.

Three aspects of how a group interacts can facilitate shared leadership: shared purpose, social support, and voice. Shared purpose means team members have a similar understanding of the team’s objective and collective goals. Social support means that team members contribute to each other’s emotional and psychological well-being by offering encouragement and assistance. Voice refers to the degree to which team members believe they have input into how the team carries out its activities. Taken together, these group dynamics can foster a sense of trust and willingness to collaborate in support of team leadership.

Shared leadership also benefits from coaching from a respected person outside of the group. An external coach can provide guidance and advice to the team and also help individuals develop their leadership skills. Through active encouragement and positive reinforcement of team members who demonstrate leadership, coaching can foster independence and a sense of individual self-efficacy. Coaching can also nurture collective commitment to the team and its objectives, increasing the possibility that team members will demonstrate personal initiative.

Team members sharing responsibility

Team members consult each other in a group that employs shared leadership.

9.6.6: E-Leadership

Leaders of virtual teams face challenges communicating and building relationships.

Learning Objective

Discuss the growing importance and technological potential of integrating leadership across chronological and geographical boundaries

Key Points

• E-leadership works across time, space, and organizational boundaries, usually strengthened by communication technology.
• Communication is more difficult on virtual teams, and virtual leaders must emphasize the importance of effective communication to achieving the team’s goals.
• A virtual team leader must be particularly attentive to the development of group norms and the emergence of trust, both of which are made difficult by the geographic separation of team members.

Key Term

E-leadership

Form of leading across time, space, and organizational boundaries, usually supported by networks of communication as well as technology.

Virtual teams are those whose members work across distances of time, space and organizational boundaries. Their interactions are made possible by information and communication technology. Such teams are formed to benefit from different sources of knowledge, to lower costs, or to create flexibility and responsiveness in staffing. By their nature, virtual teams have particular leadership needs.

Leaders of virtual teams face communication challenges. They do not have the benefit of many opportunities for rich, face-to-face interactions. The absence of in-person interaction has at least two consequences. It can take more effort to gather and disseminate information needed to support a group’s performance. It also makes it more difficult for a leader to develop relationships. The lack of social interaction can inhibit trust and group cohesion. The geographic distribution of virtual team members may also involve linguistic or cultural differences that can create barriers to effective communication. To address these communication challenges, e-leaders must communicate more frequently, provide more complete information, and use multiple means of communication technology effectively.

The virtual team leader must also encourage awareness of how group norms are developing. Without regular personal interactions, members may not be aware of how their behavior is perceived by others and how that behavior can affect the team’s performance. The virtual leader must make and share observations about how team members work together and encourage them to be attentive to the process by which they collaborate, rather than focus solely on tasks. Drawing explicit attention to group norms and reinforcing them by being a role model, the virtual leader can help build trust between team members and make them a more effective team.

9.7: Developing Leadership Skills

9.7.1: Developing Leadership Skills

Leadership skills can be learned, and leadership development benefits individuals and organizations.

Learning Objective

Discuss the varying perspectives and models that surround the leadership development field, as well as the importance of leadership development

Key Points

• The success of leadership development efforts has been linked to three variables: individual learner characteristics, the quality and nature of the leadership development program, and opportunities to practice new skills and receive feedback.
• Leadership development can take many forms, including formal training, 360-degree feedback, coaching, and self-directed learning.
• Leadership development refers to any activity that enhances the capability of an individual to assume leadership roles and responsibilities.
• Two recognized models in leadership development include the two-part model developed by McCauley, Van Veslor, and Ruderman and the General Electric model.

Key Terms

leadership development

Any activity that enhances the quality of leadership within an individual or organization.

leadership

The capacity of someone to lead.

Leadership development refers to any activity that enhances the capability of an individual to assume leadership roles and responsibilities. Examples include degree programs in management, executive education, seminars and workshops, and even internships. These types of learning opportunities focus on developing knowledge, skills, self-awareness, and abilities needed to lead effectively.

Just as not all people are born with the ability or desire to play soccer like Zinedine Zidane or sing like Luciano Pavarotti, not all people are born with the ability to lead. Personal traits and behavioral dispositions can help or hinder a person’s leadership effectiveness. While these are difficult to change, leadership is a set of behaviors and practices that can be learned through effort and experience.

Leadership traits

Leadership traits can be broken down into 6 categories: Cognitive Capacities, Dispositional Attributes, Motives/Values, Social Capacities, Problem Solving Skills, Expertise & Knowledge.

Successful leadership development is the result of three things:

1. Individual learner characteristics, including willingness and ability to learn
2. The quality and nature of the leadership development program, including its structure and content
3. Opportunities to practice new skills and receive performance feedback

Methods of Leadership Development

Leader development takes place through multiple mechanisms: formal instruction, developmental job assignments, 360-degree feedback, executive coaching, and self-directed learning. These approaches may occur independently but are more effective in combination.

Formal Training

Organizations often offer formal training programs to their leaders. Traditional styles provide leaders with required knowledge and skills in a particular area using coursework, practice, “overlearning” with rehearsals, and feedback (Kozlowski, 1998). This traditional lecture-based classroom training is useful; however, its limitations include the question of a leader’s ability to transfer the information from a training environment to a work setting.

Developmental Job Assignment

Following formal training, organizations can assign leaders to developmental jobs that target the newly acquired skills. A job that is developmental is one in which leaders learn, undergo personal change, and gain leadership skills resulting from the roles, responsibilities, and tasks involved in that job. Developmental job assignments are one of the most effective forms of leader development. A “stretch” or developmental assignment challenges leaders’ new skills and pushes them out of their comfort zone to operate in a more complex environment, one that involves new elements, problems, and dilemmas to resolve.

360-Degree Feedback

The 360-degree feedback approach is a necessary component of leader development that allows leaders to maximize learning opportunities from their current assignment. It systematically provides leaders with perceptions of their performance from a full circle of viewpoints, including subordinates, peers, superiors, and the leader’s own self-assessment. With information coming from so many different sources, the messages may be contradictory and difficult to interpret. However, when several different sources concur on a similar perspective, whether a strength or weakness, the clarity of the message increases. For this mechanism to be effective, the leader must accept feedback and be open and willing to make changes. Coaching is an effective way to facilitate 360-degree feedback and help effect change using open discussion.

Coaching

Leadership coaching focuses on enhancing the leader’s effectiveness, along with the effectiveness of the team and organization. It involves an intense, one-on-one relationship aimed at imparting important lessons through assessment, challenge, and support. Although the goal of coaching is sometimes to correct a fault, it is used more and more to help already successful leaders move to the next level of increased responsibilities and new and complex challenges. Coaching aims to move leaders toward measurable goals that contribute to individual and organizational growth.

Self-directed Learning

Using self-directed learning, individual leaders teach themselves new skills by selecting areas for development, choosing learning avenues, and identifying resources. This type of development is a self-paced process that aims not only to acquire new skills but also to gain a broader perspective on leadership responsibilities and what it takes to succeed as a leader.

Leadership Development Models

McCauley, Van Veslor, and Ruderman (2010) described a two-part model for developing leaders. The first part identifies three elements that combine to make developmental experiences stronger: assessment, challenge, and support. Assessment lets leaders know where they stand in areas of strengths, current performance level, and developmental needs. Challenging experiences are ones that stretch leaders’ ability to work outside of their comfort zone, develop new skills and abilities, and provide important opportunities to learn. Support—which comes in the form of bosses, co-workers, friends, family, coaches, and mentors—enables leaders to handle the struggle of developing.

The second part of the leader-development model illustrates that the development process involves a variety of developmental experiences and the ability to learn from them. These experiences and the ability to learn also have an impact on each other: leaders with a high ability to learn from experience will seek out developmental experiences, and through these experiences leaders increase their ability to learn.

The leader-development process is rooted in a particular leadership context, which includes elements such as age, culture, economic conditions, population gender, organizational purpose and mission, and business strategy. This environment molds the leader development process. Along with assessment, challenge and support, leadership contexts are important aspects of the leader-development model.

General Electric Model of Leadership Development

Another well-known model of leadership development is used by the General Electric Corporation. Managers with high potential are identified early in their careers. Their development is monitored and planned to include a variety of job placements to develop skills and experience, a rigorous performance-evaluation process, and formal training programs at the corporate leadership center in Crotonville, New York. For top managers, the CEO leads some of the training; the CEO also reviews performance evaluations for high-potential managers during site visits to the various subsidiary divisions.

8.4: Financial and Project Management Tools of Control

8.4.1: Gantt Charts

Learning Objective

Compare the advantages and disadvantages of utilizing a Gantt chart to illustrate a project schedule

Key Points

• Gantt charts illustrate the start and finish dates of the terminal and summary elements of a project. Gantt charts also display the expected duration of each stage of a project as well as the expected order of each stage.
• The axes of a Gantt chart include the duration (weeks, months, and so on) of each step of the project and descriptions of each step. Gantt charts can also show the completion rate of the project steps that are currently underway.
• Gantt charts help communicate the goals and objectives of projects, their timeline, and the expectations project managers have for completion rates for the project.
• Although a Gantt chart is useful and valuable for small projects that fit on a single sheet or screen, they can become too large and unruly for projects with very large numbers of activities.

Key Term

project management

The discipline of planning, organizing, securing, managing, leading, and controlling resources to achieve specific goals.

A Gantt chart is a type of bar chart developed by Henry Gantt to illustrate a project schedule. Gantt charts show the start and finish dates of the terminal and summary elements of a project. Gantt charts also display the expected duration of each stage of a project as well as the expected order of each stage.

The axes of a Gantt chart include the duration (weeks, months, and so on) of each step of the project and descriptions of each step. Gantt charts can also show the completion rate of project steps that are currently underway.

Gantt charts are used in many types of projects, including technical projects and simple projects. Today they are commonly used, but when they were first introduced Gantt charts were revolutionary.

Relevance to Management

Gantt charts are especially useful for management professionals because they display multiple steps and active components simultaneously. Management is tasked with understanding a wide variety of processes at any given instant and allocating resources or adjusting policy based upon this understanding. Gantt charts enable real-time tracking of each phase of a given project (or series of projects), and allow managers to quickly update and communicate broad arrays of information chronologically.

Advantages Of Gantt Charts

Gantt charts can be used to show the current schedule status using percent-complete shadings and a vertical “TODAY” line. Because they are so commonly used, Gantt charts can be used and understood by audiences around the world.

Gantt charts also help communicate the goals and objectives of projects, their timeline, and the expectations project managers have for completion rates for the project. They serve as a communication device among team members to discuss the goals of the project and make realistically appraisals of the current timeline. Thus they provide a useful visualization of strategy in action.

Disadvantages Of Gantt Charts

Although a Gantt chart is useful and valuable for small projects that fit on a single sheet or screen, they can become too large and unruly for projects with a large number of concurrent activities. Larger Gantt charts may not be suitable for most computer displays.

Because Gantt charts focus primarily on schedule management, they represent only one of the triple constraints for project management (cost, time, and scope–Gantt charts show only time). Moreover, since Gantt charts do not convey the size of a project or the relative size of work elements, the magnitude of steps behind schedule can be easily mis-communicated. If two projects are the same number of days behind schedule, the larger project has a larger effect on resource utilization, but this difference is not expressed on a Gantt chart.

Construction of Gantt Charts

In the following example there are seven tasks labeled A through G . Some tasks can be done concurrently (A and B) while others cannot be done until the predecessor task is complete (C cannot begin until A is complete).

Additionally, each task has three time estimates: the optimistic time estimate (O), the most likely or normal time estimate (M), and the pessimistic time estimate (P). The X axis displays the expected duration of the project and the bars show how much time each step of the project is expected to take as well as when the step will take place in relation to the rest of the project.

Gantt chart

Gantt charts are used in project management scheduling.

8.4.2: CPM and PERT Charts

Learning Objective

Outline business processes within project management utilizing the critical path method (CPM) as a control function and diagram projects within project management using the program evaluation review technique (PERT) chart

Key Points

• CPM diagrams each step of a project(s). This includes a list of tasks and the time (duration) that each task should take to complete, and the sequence of and dependencies between tasks.
• CPM uses task sequence and timing information to lay out the longest path of planned activities to the end of the project and give a time window during which the step should be completed to keep it from interfering with later steps.
• A PERT chart is a diagram for CPM that represents tasks with an arrow diagram. PERT charts are more simplistic than CPM charts because they simply show the sequence and timing of each step in the project.
• CPM/PERT charts are useful in determining where potential delays may occur in a project and deciding the sequence of tasks. This helps project managers organize tasks and ensure that time is managed appropriately at each stage of the project.
• The cumulative process of transforming various independent efforts into an interdependent value-added proposition is often complex; CPM/PERT charts allow project managers to visualize tasks chronologically.

Key Term

Critical Path

In a CPM diagram, the longest time period that any series of tasks will take. This amount of time becomes the maximum amount of time needed to complete the project.

The critical path method (CPM) is a project modeling technique that was developed in the late 1950s by Morgan R. Walker and James E. Kelley, Jr. CPM is commonly used for projects in construction, aerospace and defense, software development, research projects, product development, engineering, and plant maintenance. It is particularly useful for projects that have interdependent steps and/or processes.

CPM Inputs

CPM diagrams each step of a project(s). This includes a list of tasks and the time (duration) that each task should take to complete, and the sequence of and dependencies between tasks (such as “Step A has to be finished before moving to step B”). CPM uses task sequence and timing information to lay out the longest path of planned activities to the end of the project and give a time window during which the step should be completed to keep it from interfering with later steps.

Project managers can glean a lot of information about the timing of the project by following the pathways created in the CPM diagram between the different steps. They can determine which tasks need to be completed first and how much time can be spent on those tasks before they delay other parts of the project.

The Critical Path

Managers can also use CPM to determine which set of tasks is likely to take the longest. For example, if Step A has to be completed before Step B, which has to be completed before moving to Step C, but Steps D, E, and F can all be completed independent of each other, Steps A, B and C form the longest series of tasks in the project.

The longest series of tasks in a project is referred to as the “critical path;” in this case, it would be A–>C. The critical path is the sequence of project network tasks that combine for the longest overall duration. The critical path also tells the project manager the shortest possible time period in which the project can be completed since the timing of the project will be dependent on the completion of critical path tasks.

PERT Chart

A PERT chart (program evaluation review technique) is diagram for CPM that represents tasks with an arrow diagram . PERT charts are more simplistic than CPM charts because they simply show the timing of each step of the project and the sequence of steps.

PERT chart

A PERT chart shows the timing of a project.

Standard CPM charts are more complex than PERT charts because they illustrate the sequence of steps and place a diagram around each step that shows the earliest and latest possible time that each task in the project can be completed.

CPM Chart

A CPM chart is similar to a PERT chart but includes more detail about the latest and earliest possible times at which each stage of the project must be completed. The earliest possible time (in green) are calculated by determining the earliest start times of all activities on the critical path before that activity. The latest possible times (in blue) are calculated by adding all of the latest possible times of the activities before the critical path. In this CPM chart, the critical path is A-B-C-D-E since that pathway takes the most time to complete of any of the other potential pathways available. The total float time (lime green), or TF, represents the amount of time flexibility a task has between start and end times.

Managerial Implications

CPM/PERT charts are useful in determining where potential delays may occur in a project and deciding the sequence of tasks. This helps project managers organize tasks and ensure that time is managed appropriately at each stage of the project.

Project managers are master multitaskers, capable of seeing the forest of the long-term agenda through the trees of short-term objectives. The cumulative process of transforming various independent efforts into an interdependent value-added proposition is often complex; CPM/PERT charts allow project managers to visualize tasks chronologically. This time component is critical because understanding the prerequisites for each stage of development minimizes delays and ensures ideal resource allocation.

Finally, the concept of a critical path is integral to the usefulness of the model. Identifying which task grouping will determine the overall length of the project allows proper prioritization and enables deadlines to be shortened through increased effort in specific areas. This makes it easier for the project manager to effectively add value by reducing lead times.

8.4.3: Financial and Budgetary Controls

Learning Objective

Use effective budgeting techniques and financial projections to maximize the potential success and control project objectives

Key Points

• Determining the cost of a project is one of the most important initial steps for a project manager (PM). Financial and budgetary controls are critical tools in this process.
• Some tools that project managers can use to control finances and budgeting include payback period and other financial forecasting calculations, as well as budgeting techniques like variance analysis.
• One way to determine whether the budgeting plan is being adhered to is to compare the budget allotted for a certain period of time with the actual amount of money spent during that time. This is called a variance analysis.
• Financial forecasting calculations include basic payback periods and net profit values (NPVs) which calculate the period of time required for the return on an investment to repay the sum of the original investment.
• It is important for a project manager to conduct these financial forecasting calculations and budgeting controls to identify budgetary constraints well before costs are incurred.

Key Term

Variance analysis

The difference between a budgeted, planned, or standard amount and the actual amount incurred/sold. This difference can be computed for both costs and revenues.

Why Managers Use Budgetary Controls

Determining the cost of a project is one of the most important initial steps for a project manager. If a project manager cannot stay within a controlled budget, they may not have the funds to complete the project. The budget and financial plan is typically created during the initial stage of project development. Costs and resources should be set during the initiation stage to adequately plan and allocate costs.

Some tools that project managers can use to control finances and budget include payback period and other financial forecasting calculations, and budgeting techniques, including variance analysis. These tools are critically important for project managers who need to control resources to ensure project completion. If resources are mismanaged, the project will be characterized by sunk costs (i.e., investments that procure no returns).

Budgeting Techniques

Budgeting involves determining how much money will be needed to complete a project and the timeframe for spending it. The budget may be determined on an annual or monthly basis depending on how long the project is projected to run. An important part of budgeting is setting a plan that can be followed over the course of the project.

Example Budget Plan

Budget plans can be used to project incomes and expenses over the span of several months.

One way to determine whether the budgeting plan is being adhered to is to compare the budget allotted for a certain period of time with the actual amount of money spent during that time. This is called a variance analysis. A variance is the difference between a budgeted, planned, or standard amount and the actual amount incurred/sold. Variances can be computed for both costs and revenues to show a project manager whether they are adhering to the project budget.

Financial Forecasting Calculations

Financial forecasting calculations, such as payback periods, calculate the period of time required for the return on an investment to repay the sum of the original investment. For example, a $1,000 investment that returned $500 per year would have a two-year payback period. Payback period intuitively measures how long something takes to “pay for itself.” All things being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because it is a simple and clear measure.

Payback period is limited by the fact that it does not include the time value of money; that is, people prefer to receive money sooner rather than later. Net present value (NPV) is a financial forecasting calculation that does include the time value of money. It determines the “current value” of a sum of money on an annual (or monthly) basis, the value that cash paid out years from now would have if it was paid out today. This is a complex financial forecasting model that derives real rate of return using interest and inflation to localize currency chronologically.

Both payback period and NPV can be used in project management in order to determine how much profit a project will bring in and when. It is important for a project manager to conduct these financial forecasting calculations and budgeting controls to identify budgetary constraints well before costs are incurred and to secure funding from top management. Once a project receives funding, the project manager will need to use budgeting controls such as variance analysis in order to stay within the budget and ensure the success of the project.

8.4.4: Project Management Audits

Learning Objective

Identify how project managers can use the common accounting concept of audits to achieve optimal levels of control and efficiency

Key Points

• In project management and quality management, managers audit the steps and/or processes of a project systematically or randomly to ensure that it is meeting estimated completion and quality standards.
• An internal audit in project management is usually more or less like a check-up: it assesses the current state of a project and prescribes actions that will increase its success.
• A regulatory audit is an external verification that a project is compliant with regulations and standards.
• It is important to monitor how an audit is conducted so that employees or project team members don’t perceive it as a sign that the project manager does not trust them to complete their work.
• Project managers benefit from periodic auditing in two broad ways: collecting performance data and ensuring managerial presence in various phases of the project.

Key Term

Best practice

A method or technique that has consistently shown better results than others, and is used as a benchmark.

The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product.

Project Management Audits

This usually refers to audits in accounting, but similar concepts also exist in project management and quality management, as the auditing of steps and processes in a project systematically or randomly to insure that the project is meeting estimated completion and quality standards.

Like a project management audit, a quality audit is an external verification that a project is compliant with regulations and standard. A system of quality audits verifies the effectiveness of a quality management system. To benefit the organization, quality auditing should highlight areas of good practice and provide evidence of conformance (positive feedback) as well as report non-conformance and corrective actions (negative feedback).

Types of Audits

An internal audit in project management is usually more or less like a check-up: it assesses the current state of a project and prescribes actions that will increase its success. Audits in project management also include regulatory audits to provide external verification that a project is compliant with regulations and standards. Best practices of auditing dictate that a regulatory audit must be accurate, objective, and independent while providing oversight and assurance to the organization.

Why Project Managers Audit

Audits generally provide a good understanding of how a project is running and how in/effectively the project team is. Project managers benefit from periodic auditing in two broad ways. First, managers gain tangible data about specific components of the process performance and a good handle on how the project is aligning with long-term objectives. Second, auditing ensures that employees and contractors are aware of managerial presence (which motivates better performance) and show support for various elements of the project.

It is important, however, to monitor how an audit is conducted so that employees or project team members don’t perceive it as a sign that the project manager does not trust them to complete their work. If team members are aware that an audit is coming, or if they have discussed the possibility with the project manager, they may be more open to the idea. If an audit comes as a surprise, it can create lack of trust and suspicion between the project manager and their team. It is important to consider interpersonal factors before conducting an audit of a project.

Auditing and Communicating to a Project Team

When auditing a project, the project manager needs to be clear that the project team does not become suspicious or feel threatened by it.

8.4.5: Project Management Inventory

Learning Objective

Discuss the importance of inventory management in maximizing utilization and achieving strong performance metrics

Key Points

• PMs are constantly using inputs to generate outputs in standard operational processes, which necessitates a number of potentially costly inventory components.
• PMs strive to control the timing of inventory, the uncertainty of demand and supply availability, and overall economies of scale.
• A PM should leverage various technologies to better gather real-time inventory data. This could include RFID tags, bar codes, QR codes, and inventory management software integration.

Key Terms

QR Code

Black modules (square dots) arranged in a square grid on a white background that can be read and processed by an imaging device (such as a camera).

RFID Tag

Wireless tags with electromagnetic fields to transfer data, for the purposes of automatically identifying and tracking tags attached to objects.

An important consideration when determining how to best manage a project is inventory. Project managers (PMs) must manage all resource inputs for a given project; how they approach this can increase or reduce costs dramatically. From a project management standpoint, it is essential to track current inventory and create a process for managing inventory flow.

Why Track Inventory?

PMs are constantly using inputs to generate outputs in standard operational processes, which necessitates a number of potentially costly inventory components. For example, if a given project involves perishables (such as food), there is a definite time limit on product value–once perishables spoil, their product value is zero. Careful chronological and quantity-based inventory questions must be answered to create a process flow that ensures the value of the goods being sold. In short, there are three general reasons to manage inventory:

• Time – Time lags in the supply chain at every stage from supplier to user require PMs to maintain certain amounts of inventory to use in this lead time.
• Uncertainty – Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods.
• Economies of scale – The ideal condition of “one unit at a time at a place where a user needs it, when he needs it” tends to incur a lot of logistical costs that result in bulk buying, transporting, and storing the goods.

Since inventory tends to get overstocked and is typically not well-managed, there may be a multitude of supplies that no one is using. PMs can use a number of inventory management techniques to cut costs and streamline operations and ensure that optimal quantities are bought, stored and distributed.

Inventory Management Tools

Technology has dramatically changed the inventory management process. PMs can use technology to track real-time inventory statistics. A number of recent technological developments in inventory management include:

• RFID Tags – RFID (radio-frequency identification) tags are used to track the locations of various items, from components in an automobile assembly line to boxes of cereal shipped from a manufacturing plant to the grocery store. These little tags communicate vast arrays of location data to inform timing processes and ensure proper inventory levels.
• QR Codes – QR codes originated in logistics but have become popular in marketing as well. In the 1990s, QR codes were used for rapid component scanning linked to computer data systems to paint clear pictures of inventory process flows.
• Bar Codes – Like QR codes, bar codes are used to scan inventory information into a computer data system. When you purchase an item at a store, the bar code is scanned so that the manufacturer’s inventory system can remove that item from their list of inventoried goods (transferring it to the income statement as revenue).
• Inventory Management Software – Each of the devices listed above requires a logistics software package capable of streamlining all of this data into a meaningful view of the supply chain. Inventory management control systems are the heart of inventory management for PMs because they provide information output to be manipulated, analyzed, and assessed to better understanding the inventory process.

RFID tree

This image illustrates the information flow of RFIDs, which is then streamlined into large data streams for PMs to track.

QR code example

Above is a description of a QR code, along with the data implications of various visual aspects of the image (which are processed and reported via software). Different components of the code reflect position, alignment, and timing.

8.4.6: Break-Even Analysis

Learning Objective

Employ a break-even analysis and derive a break-even point when analyzing a business initiative or project

Key Points

• In economics and business, the break-even point (BEP) represents the point at which there is no net loss or gain because costs and revenue are equal.
• BEP, in the control sense, is a feasibility model for continuing an existing operation or opening a new one.
• Break-even analysis represents the minimum quantity a company needs to sell to cover costs like rent, building expenses, utilities, and other aspects of day-to-day operations.
• As long as a business can cover the minimum costs, it is “breaking even” and can remain in business without turning a profit.
• Break-even analysis lets companies compare their production or sales numbers with the minimum they need to achieve in order to stay in business.

Key Term

fixed costs

Business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month.

Break-Even Point

In economics and business, the break-even point (BEP) is when costs (or expenses) and revenues are equal: there is no net loss or gain and the business has “broken even” by earning back its costs.

Identifying BEP

Break-even analysis determines the minimum quantity a company needs to sell in order to cover its minimum costs, including rent, building expenses, utilities, and the operational costs of running day-to-day operations. As long as a business can cover its minimum costs, it is “breaking even” and can remain in business even if it is not turning a profit.

For example: a business selling tables has a BEP of 200 tables per month. If the company sells fewer than 200 tables each month, it loses money; if it sells more, it makes a profit. Business leaders use this information to determine whether or not they will produce and sell 200 tables per month and proceed based on that analysis. If they estimate they cannot sell that many, they can reduce their fixed costs (renegotiating rent, keeping phone bills or other expenses down), reduce variable costs (paying less for materials per item produced, usually by finding a new supplier), or raise the price of their tables. Any of these approaches would lower the break-even point; the company might only need to sell 150 tables per month and pay its fixed costs if it can cover or alter them through other means.

A break-even analysis is typically depicted by a graph showing the midpoint between profit and loss with the axes as units sold and price of goods sold. The graph shows when sales can cover fixed costs so the company will be able to stay in business in the short-term. Over a longer period of time, other factors can come into play, like changes in rent or quantity sold, or other competitors entering the market.

Break-even analysis

Break-even points can be determined based on sales and total costs. The point is found at the number of units where loss and sales are equal.

Project Managers and Break-Even Analysis

Break-even analysis lets companies compare their production or sales with the minimum point (the break-even point) they need to achieve in order to stay in business. Typically, companies want to produce above BEP in order to make a profit and will adjust their output level to surpass the break-even point.

Because they are in charge of specific process flows, understanding BEP and how to lower it through operational efficiency is central to the responsibilities of a project manager (PM). When making financial projections or pitching a new line of goods, the PM must estimate BEP and how they can exceed it in a given market. BEP, in this sense, is a feasibility model for either continuing an existing operation or opening a new one.

8.4.7: Ratio Analysis

Learning Objective

Recognize the importance of ratios and ratio analysis in financial assessment and project control

Key Points

• In project management, ratio analysis may evaluate the efficiency of the project and how well the project managers are controlling resources.
• Financial ratios in the corporate setting usually come from a company’s balance sheet and income statement. These can include profitability ratios, efficiency ratios, activity ratios, and debt ratios. They can be applied to individual projects as well.
• Ratios used to determine a project’s health include operating margins, profitability margins, efficiency ratios, and debt.
• Project managers should consider these ratios in relation to past, present, and future projects, making sure that they are investing in a project that will produce the best value for their dollar.
• The goal of any organization is profits, and ratio analysis allows organizations to see where dollars are being invested and the results on that investment in terms of profitability percentage.

Key Term

benchmark

When a manager compares metrics such as quality, time, and cost across an industry and against competitors.

Ratio analysis is used in finance and accounting to determine how a company is performing financially compared with other companies; efficiency and other production metrics may also be assessed. In project management, a ratio analysis may be related to the efficiency of a project and how well the project managers are controlling resources.

Financial Ratios

Financial ratios in the corporate setting usually come from a company’s balance sheet and income statement. These can include profitability ratios, efficiency ratios, activity ratios, and debt ratios. These are typically used to determine a company’s financial health relative to industry benchmarks, but they can also be used to maintain financial control of specific projects by assessing their financial health.

Ratios used to determine a project’s health include operating margins, profitability margins, efficiency ratios, and debt. Operating margin and total margin calculate the revenue a project is producing over expenses (a profitable output ratio). Operating margin considers only operating revenues and expenses (such as salaries, utilities, supplies) while total margin considers all revenues and expenses. There are many smaller ratios built into these broader operating margins as well, including output per employee, inventory turnover, and specific cost components in comparison with one another.

Other efficiency ratios that the project management team may consider include staff productivity levels, the number of activities completed in a set period, and expenses in relation to productivity.

Operating margin formula

The operating margin is found by dividing net operating income by total revenue.

Application to Control

All of these ratios give the project manager a better sense of the health of the project. Project managers should consider these ratios in relation to past, present, and future projects, making sure that they are investing in a project that will produce the best value for their dollar.

The goal of process control is increased efficiency; ratio analysis uses a wide variety of point in similar projects as benchmarks to denote where efficiency can be enhanced, and underlines differences in profitability and efficiency that may sway resource allocation for the organization in the future.

The goal of any organization is profits, and ratio analysis allows organizations to see where dollars are being invested and the results on that investment in terms of profitability percentage. Project managers must justify their projects in this context to appease managerial concerns and considerations; thus ratio analysis is also useful in ensuring the viability and likelihood of renewal for a given project.

8.5: Scorecard Management

8.5.1: Balanced Scorecards

A balanced scorecard is a device that managers use to convey performance across a range of relevant strategic criteria.

Learning Objective

Review the four primary perspectives addressed by a balanced scorecard

Key Points

• Criteria are generally a mix of financial and non-financial indicators: measures of success and failure differ according to the type of indicator.
• The balanced scorecard represents performance pictographically; its original design was a table broken up into sections, or perspectives, that generally included financial, customer, internal business processes, and learning and growth.
• A balanced scorecard aggregates performance within a single framework. It should convey performance to stakeholders simply and quickly.
• This visual tool gets each of the moving parts in an organization on the same page to ensure continuity and synergy between functional aspects.

Key Terms

Key Performance Indicator

An industry term for a type of performance measurement; usually used by an organization to evaluate its success.

strategic management

The art and science of formulating, implementing, and evaluating cross-functional decisions that will enable an organization to achieve its objectives.

Balanced Scorecards Defined

A balanced scorecard is a semi-standardized strategic management tool used to track, monitor, update, and improve key performance indicators (KPI) within an organization. These variables are generally a mix of financial and non-financial indicators that allow managers to better control strategic operational and financial commercial outcomes. The balanced scorecard is currently one of the most popular management tools used for tracking organizational performance

The balanced scorecard

On a standard balanced scorecard each”perspective” reminds the user to articulate attributes necessary for an effective scorecard: the financial perspective, the customer’s perspective, innovation, and internal processes, all of which come together to form an organization’s vision and strategy.

Originally created in 1987 by Art Schneiderman, an executive at the semiconductor firm Analog Devices, the balanced scorecard is an adaptation of early performance measurement techniques that were developed in complex post-industrial corporations in the U.S. and Europe.

Balanced Scorecard Perspectives

The balanced scorecard represents performance pictographically; its original design was a table broken up into sections, or perspectives, that generally included financial, customer, internal business processes, and learning and growth. Each perspective then included a set of five or six measures that could be compiled to inform the raw score for the corresponding perspective.

The four perspectives are:

• Financial: This section encourages the identification of a few relevant high-level financial measures that help companies to answer the question “How do we look to shareholders?”
• Customer: This section encourages the identification of measures that answer the question “How do customers perceive us?”
• Internal Business Processes: This section encourages the identification of measures that answer the question “What must we excel at?”
• Learning and Growth: This section encourages the identification of measures that answer the question “How can we continue to improve and create value?”

Managerial Use of the Scorecard

As organizational acceptance of performance management tools grew throughout the 1990s, the original design of the balanced scorecard evolved to include a host of other variables and considerations, most significantly at the intersection of performance and strategy.

Corporate strategic objectives were added to justify focusing on certain perspectives, effectively absorbing the original framework into a more comprehensive strategic planning exercise. Today, this second-generation balanced scorecard is often referred to as a “strategy map”, but the vernacular “balanced scorecard” is still used to refer to anything consistent with a pictographic strategic management tool.

Managers generally use this tool to identify areas of the organization that need improved alignment and control with the broader organizational vision and strategy. The balanced scorecard gets each of the moving parts in an organization on the same page to ensure continuity and synergy between functional aspects.

8.5.2: Visual Scorecards

The visual scorecard is a graphic analogy of the balanced scorecard framework and a key visual link between performance and strategy.

Learning Objective

Produce a visual representation of a balanced scorecard for communication and meetings

Key Points

• If the balanced scorecard is the whole process of developing perspective, measures, and targets, then the visual scorecard is the graphic depiction of those interactions.
• Although classically depicted as major perspectives encircling the organization’s overall vision or strategy, there is no widely accepted format for the visual scorecard; any format that effectively communicates performance to stakeholders will work.
• Managers rely on the visual scorecard to quickly diagnose positive or negative performance throughout an organization.

Key Term

Strategy Mapping

An articulation of organizational perspectives and key goals.

Balanced Scorecard Illustrated

A balanced scorecard is the sum of all relevant inputs; the visual scorecard is the graphic representation of findings or results. Think of the visual scorecard as a tool for presenting data to managers of board members at an organizational strategy meeting.

This image represents the classic visual scorecard, in which “perspectives” of strategic importance are organized around a higher-level vision or strategy. The visual scorecard does not always have to be in this format; it may appear as a matrix, or a series or matrices that cross-reference issues of strategic importance with objectives or measures within the major perspectives.

The cyclical visual scorecard with four components (financial, internal, innovation, and customer) is a very common design that successfully bridges performance and strategy. Recent design enhancements to visual scorecards include the use of red (danger), yellow (caution), and green (safe) color schemes to reflect various performance attributes. An abundance of red immediately sends a signal to managers that serious improvement is needed in order to satisfy organizational targets. Similarly, the presence of green indicates that the targets are being met or exceeded.

Why Use Visual Scorecards?

A good visual scorecard is easily deciphered by all stakeholders, immediately conveying areas of strength, weakness, success, or deficiency. Visual scorecards make the data in balanced scorecards instantly readable.

When communicating business processes to stakeholders, managers are often tempted to rely on jargon and detail-oriented descriptions of strategy and process. The visual scorecard gives stakeholders a clear understanding that jargon and business-speak may not. It is primarily a communication tool.

8.5.3: Scorecard Measurement

Balanced scorecard measurements require extensive data collection and are essential in validating scorecard outputs.

Learning Objective

Indicate the value of measuring progress on objectives in effectively employing a score card in the workplace

Key Points

• The balanced scorecard ultimately helps managers choose measures and targets. If these aspects of the scorecard are not well-selected then the results will be neither useful nor reliable.
• Scorecard design is also critical. If managers decide that a balanced scorecard should include performance measurements from the perspective of the “Customer”, then an objective of success must be defined for the actual performance data to be effective.
• Gap analysis is a tool that helps companies compare actual performance with potential performance. At its core are two questions: “Where are we?” and “Where do we want to be?”.
• Coupled with well-designed and well-thought out dimensions for the scorecard itself, gap analysis is very useful in assessing organizational health.

Key Terms

Gap Analysis

A tool that helps organizations compare actual performance with potential performance. It answers the question: “Where are we now and where do we want to be?”

ex-ante

Latin for “beforehand” or “in advance of.”

ex-post

Latin for “after the fact.”

Scorecard Design and Feedback

The balanced scorecard is ultimately about choosing measures and targets. Its various design methods are meant to help identify these measures and targets, usually by a process of abstraction that narrows the search space for a measure. For instance, a company can find a measure to inform about a particular objective within the Customer perspective rather than find a measure for customers in general. This gives the scorecard more practical value.

Useful measurement feedback from a balanced scorecard is also essential. This means that careful consideration is required when interpreting applicable measurements. For example, if managers decide that a balanced scorecard should include performance measurements from the perspective of the “Customer”, then they must define particular objectives of success, such as customer retention longevity, repeat sales, or customer willingness to recommend a product or service. These concrete objectives allow the actual performance data to resonate and generate meaningful results.

Units on a Tape Measure

A balanced scorecard should include specific details, like the units on a tape measure, so that the scorecard can yield useful results.

Gap Analysis

Gap analysis is a tool that helps companies compare actual performance with potential performance. At its core are two questions: “Where are we?” and “Where do we want to be?”. If a company or organization does not make the best use of existing resources, or foregoes investment in capital or technology, it may produce or perform below its potential. Gap analysis can be conducted from the following perspectives:

1. Organizational
2. Business direction
3. Business processes
4. Information technology

Gap analysis lends itself to the measurement aspect of the balanced scorecard, ensuring that maximum value may be derived from the exercise. It enables management to look carefully at each objective through the lens of the four perspectives listed above and identify efficacy or room for improvement. Coupled with well-designed and well-thought out dimensions for the scorecard itself, gap analysis is very useful in assessing organizational health.

It is important to note that there are no hard-and-fast rules about defining measures and targets within a balanced scorecard. For example, financial measures can be defined as discrete values in the context of accounting ratios and continuous values in the context of dollar figures. What is important is that the data collected should be appropriately analyzed within the context of the targets and performance goals of the organization.

8.6: Managing Control

8.6.1: Elements of Managing Control

The key elements of a control process include a characteristic to be tested, sensors, comparative standards, and implementation.

Learning Objective

Model an effective managing control procedure that incorporates the key components required for effective control processes

Key Points

• A significant part of a manager’s job is to control the processes involved in the successful operation of a business. This control process consists of key elements that management must be aware of before designing control systems.
• Because organizational systems are large and complex, it is virtually impossible to control every aspect of their operation. Controllers can, however, determine the key conditions or characteristics of output and monitor them.
• After determining a condition(s), managers must integrate the various communications and data collecting sensors that procure and pass information from the system to management.
• Information should be collected and interpreted in a timely and accurate way by management and then benchmarked against previously stated organizational or competitive standards.
• Finally, after collecting data and comparing it with desired standards, an implementation strategy for alterations can be integrated into the existing process.
• While each of the key elements is a standalone component of the process, value is derived from the integration of the moving parts.

Key Term

procure

To acquire or obtain.

A significant part of a manager’s job is to control the processes involved in the successful operation of a business. This control process consists of key elements that management must be aware of before designing control systems. While each control system is unique because it is based on the process being observed, the key elements should be factored in wherever applicable. These include the characteristic or condition being controlled, the sensor, the comparator, and the activator.

The Key Elements of Control

While each of the key elements is a standalone component of the process, value is derived from the integration of the moving parts. Controllers and project managers are tasked with recognizing and assessing each element and the relationships between them. The elements include:

Condition or Characteristic – Because organizational systems are large and complex, it is virtually impossible to control every aspect of their operations with rigid control mechanisms. Controllers can, however, determine the key conditions or characteristics of output and monitor them. For example, if an organizations focuses on quality and durability, then the control factors should be testing the consistency of quality and the overall durability in the outputs of the system.

Sensor – After determining a condition(s), managers must integrate the various communications and data collecting sensors that procure and pass information from the system to management. This can be done using various logistics tools (bar codes, data manipulation software, etc.) to provide the controller a source of accurate and timely information relevant to the overall performance of the process. It is important that the communication is carefully worded, as mis-communication and misinterpretation of date can lead to costly mistakes.

Comparison with Standards – Information should be collected and interpreted in a timely and accurate way by management and then benchmarked against previously stated organizational or competitive standards. At this point, deviations from the expected outcomes and/or desired results can be noted and implementation discussed. If the system is too far outside of controlled standards to have a viable solution, the project may be shut down.

Implementor – Finally, after collecting data and comparing it with desired standards, an implementation strategy for alterations can be integrated into the existing process. This is often referred to as a series of corrective actions that address and test issues with the process in the next control cycle.

As implied above, this process is iterative. As long as there are outputs being produced and inputs being consumed, the organization will conduct productivity assessments in a control function to improve the overall efficiency of the organization. The key components of any control sequence will underline these four elements.

8.6.2: Barriers to Managing Control

Barriers to managing control include lack of resources, inaccurate measurements, improper information flow, and incorrect analyses.

Learning Objective

Outline the most common barriers encountered by managers working to manage control within an organization

Key Points

• Managing control is essential to making sure that a process or system is running effectively within an organization.
• A lack of resources can inhibit a company’s ability to manage control. Resources that can improve managing control include trained staff, statistical software, and accurate measurement systems.
• Inaccurate measurement while managing control can occur for a number of different reasons. It can be avoided by having accurate measurement systems and appropriately trained staff.
• The time lag in information flow can misdirect management to problems at the wrong time in the sequence.
• Analyzing data from a measurement to determine how to improve and better manage control of the system can also be a barrier.

Key Term

Scarcity

An inadequate amount of something; shortage.

Managing control is essential to making sure that a process or system is running effectively within an organization. There are sometimes barriers to testing, measuring, communicating, or observing how effectively a system or process is running. These barriers can reduce the efficacy of the organization, not only in the process being controlled but also in the controlling process. Barriers to organizational control can include scarcity of resources, inaccurate measurements of the process, improper information flow, and incorrect analyses.

Resource Scarcity

Managing control typically requires a number of resources. These resources include supervisory staff, skilled specialists, tools to measure the control of the system, and often complex statistical software and other tracking technologies. A lack of any (or all) of these crucial inputs can drastically reduce the ability of the control team to collect and communicate their findings. This under-funding of the control system creates resource scarcity for the process.

Inaccurate Measurement

Inaccurate measurement while managing control can happen for a number of different reasons, including:

• Inaccurate measuring devices
• Misunderstanding of the measurement process by staff
• Inaccurate or misleading measurement processes
• Lack of staff training to determine how to measure the control process

These issues can result in inaccurate measurements, which can make the control process more of a danger to the evolution of the process than an asset. All measurement tests need to be tested themselves; an understanding of best practices in taking measurements is critical in project managment.

Information Flow Issues

A particularly complex barrier to offset is information flow. Information is collected at one point in the process and analyzed contextually at another. This time lag in information flow can misdirect management to problems at the wrong time in the sequence. Ensuring timely discovery and reporting of measurements mitigates this risk.

Oscillation and feedback

Output changes over time, creating room for error in the measurement process. Because there is necessarily a delay between measuring data, analyzing the data and identifying a problem, and ultimately implementing a solution, solutions may be implemented after the problem is no longer relevant (as shown in the graph—output is already improving before the solution for the prior dip in output is implemented). Timely discovery and reporting of measurements helps minimize this problem of delay in information flow.

Even with adequate resources to manage control and accurate measurement and information flow, barriers to analyzing data can still appear. These can be introduced by human error or software error. It is useful to think statistically: a good manager will consider a 99% confidence interval that a given process is underperforming as sufficient evidence to take action to improve it, despite the fact that one time out of a hundred the issue will not be significant. Even one failure out of one hundred adds up in an organization with thousands of processes to monitor.

A lack of resources, inaccurate measurements, information flow errors, and incorrect analyses can all result in significant barriers to managing control of a process or system. Managers should be aware of these barriers and do their best to avoid them through training and accuracy.

8.7: Managing Productivity

8.7.1: Defining Productivity

In control management productivity is defined as the overall efficiency and output of a given operational system.

Learning Objective

Define productivity in the context of management and control

Key Points

• Productivity is defined as a total output per one unit of a total input. In control management, productivity is a measure of how efficiently a process runs and how effectively it uses resources.
• At the plant level, common input statistics are monetary units, weights or volumes of raw or semi-finished materials, kilowatt hours of power, and worker hours.
• Output is simply the rate of which goods are being produced and readied for sale. Managing production levels is part of the control process.
• Productivity growth is important to a business because it controls the real income means needed to meet obligations to customers, suppliers, workers, shareholders, and governments (taxes and regulation).

Key Terms

input

Something fed into a process with the intention of it shaping or affecting the outputs of that process.

productivity

The rate at which goods or services are produced by a standard population of workers.

Productivity

Productivity–a ratio of production output to the input required to produce it–is one measure of production efficiency. Productivity is defined as a total output per one unit of a total input. Control management must implement control processes to maintain or improve productivity.

Inputs

At the plant level, common input statistics are monetary units, weights or volumes of raw or semi-finished materials, kilowatt hours of power, and worker hours. These are tracked as sets of partial productivity, such as kilowatt-hours per ton or yield (weight of output divided by weight of input), both of which are used in the chemical, refining, wood pulp, and other process industries. Quality statistics like defect rates are tracked in the same way. Summary reports are routinely issued to various departments and department managers are held accountable for managing inputs in their respective areas.

Outputs

Output is simply the rate of which goods are being produced and readied for sale. Managing production levels is part of the control process–management teams must predict demand to avoid market saturation.

From the control manager’s point of view, more outputs from the inputs describe above is a step in the right direction. Finding ways to streamline internal operations to minimize cost, limit resource use, and optimize performance (quality) is the control manager’s central responsibility. Productivity in producing outputs, in short, can determine a control manager’s success or failure.

Productivity and the Firm

Productivity growth is important to a firm because more real income means the firm can meet its obligations to customers, suppliers, workers, shareholders, and governments (taxes and regulation), and still remain competitive or even improve its competitiveness in the marketplace.

Productivity is one of the main concerns of business management and engineering. Practically all companies have established procedures for collecting, analyzing, and reporting productivity data. The accounting department typically has the overall responsibility of collecting, organizing, and storing data generated by various departments.

Improving Productivity

Many companies have formal programs for improving productivity via existing control systems. Companies are constantly looking for ways to improve quality, reduce downtime, and increase inputs of labor, materials, energy, and purchased services. Simple changes to operating methods or processes can increase productivity (think Henry Ford’s assembly line). The biggest gains often come from adopting new technologies or concepts, which requires capital expenditures for new equipment, computers, or software.

Textile manufacturing

During the Industrial Revolution, productivity increased with the implementation of the assembly line.

8.7.2: The Importance of Productivity

Productivity is the ratio of total output to one unit of total input; high productivity means larger capital gains.

Learning Objective

Illustrate the critical importance of assessing and managing productivity in the control process

Key Points

• Productivity is a measure of the efficiency of production. High productivity can lead to greater profits for businesses and greater income for individuals.
• The control managers in a given organization are tasked with maximizing productivity through process-oriented observations and improvements.
• Five main processes affect productivity: real process, income distribution, production process, monetary process, and market value.
• For businesses, productivity growth is important because providing more goods and services to consumers translates to higher profits.

Key Terms

ratio

A number representing a comparison between two things.

macroeconomic

Relating to the entire economy, including growth rate, money and credit, the total amount of goods and services produced, total income earned, the general behavior of prices, and more.

microeconomic

Relating to the decision-making behavior of individual households and firms that must allocate limited resources. Typically, it applies to markets where goods or services are bought and sold.

Definition of Productivity

Productivity is a measure of the efficiency of production. It is a ratio of actual output (production) to what is required to produce it (inputs). Productivity is measured as a total output per one unit of a total input. Control managers in a given organization are concerned with maximizing productivity through process-oriented observations and improvements.

For businesses, productivity growth is important because providing more goods and services to consumers translates to higher profits. As productivity increases, an organization can turn resources into revenues, paying stakeholders and retaining cash flows for future growth and expansion. Productivity leads to competitiveness and potentially competitive advantages.

Productivity Gains

Wheat production has increased as the productivity gains improve, particularly since the 1980s.

Processes that Affect Productivity

A producer can be broken down five main processes, each with a logic, objectives, theory, and key figures of its own. The main processes of a company are:

• Real process
• Income distribution process
• Production process
• Monetary process
• Market value process

Controllers in an organization are responsible for understanding each of these elements. Real process and production process are often seen as focal points in efficiency, but monetary concerns and market value are also very important. For example, Starbucks must regularly buy a huge volume of coffee beans. Those coffee beans are vulnerable to plant diseases and other factors that could make them scarce. The price of coffee beans in dollars is therefore an enormous monetary risk for the company because resource scarcity could raise its expenses exponentially. Its controllers must hedge against these risks.

• Real process – Real process generates the production output from input. It can be described by the production function. This refers to a series of events in production in which inputs of different quality and quantity are combined into products of different quality and quantity. Products can be physical goods, immaterial services, or combinations of both.
• Income distribution – Income distribution process refers to a series of events in which the unit prices of constant-quality products and inputs change, causing an alteration in the income distribution among those participating in the exchange. The magnitude of the change in income distribution is directly proportionate to the change in the price of the outputs and inputs and to their quantities. For example, productivity gains are distribute to customers as lower prices, which may lead to higher sales revenues. Productivity gains can also be distributed to employees in the form of higher wages.
• Production process – Production process is the real process and the income distribution process. Profitability is both a result and a criterion of business success. Profitability of production is the share of the real process result that the owner has been able to retain in the income distribution process (profits earned). Factors describing the production process are the components of profitability, which are revenues and expenses.
• Monetary and market value processes – Monetary process refers to financing a business and the inputs of production. Market value process refers to a series of events in which investors determine the market value of the company in the investment markets.