Business Management for Logisticians

This project has been funded with support from the European Commission. This publication reflects the views only of the author,

and the commission cannot be held responsible for any use which may be made of the information contained therein.

Business Management for Logisticians (Core management skills and Business Principles)

Kornélia Lazányi

&

Jan Vlachý

Business Management for Logisticians

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Kornélia Lazányi & Jan Vlachý

Poznan School of Logistics

Poznan, 2020


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Publisher:

Wyższa Szkoła Logistyki

Estkowskiego 6

61-755 Poznan, POLAND

www.wsl.com.pl

Editorial College:

Marek Fertsch, Ireneusz Fechner, Stanisław Krzyżaniak (chairman), Aleksander Niemczyk, Bogusław

Śliwczyński, Ryszard Świekatowski, Kamila Janiszewska

ISBN 978-83-62285-35-8 (Online)

Book has been edited by Wyższa Szkoła Logistyki.

Copyright © by Wyższa Szkoła Logistyki

Poznan 2020, Issue I

Editors: Kornélia Lazányi & Jan Vlachý

Technical editors:

Adrianna Toboła, Wyższa Szkoła Logistyki, Poznan, Poland

Eva Zaksevicka, Czech Technical University, Prague, Czech Republic

Cover design:

Miłosz Margański

The book has been written in Master Logistics Learning project (MLL) [2017-1-PL01-KA203-

038698] financed by ERASMUS+ programme.

This project has been funded with support from the European Commission. This publication reflects

the views only of the author, and the Commission cannot be held responsible for any use which may

be made of the information contained therein.

The book is open access and available at: logisticsmodule.eu

The entire book has "open-access" license and offers free access to the full text of all chapters via its

website. All chapters are released under the Creative Commons CC BY-NC license (Attribution-

Noncommercial).


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Authors of the Chapters: • Part A - Core Management Skills – prof. Kornélia Lazányi

• Part B - Business Principles – prof. Jan Vlachý

Reviewers:

• Dr. eng. Stanislaw Krzyzaniak – Lukasiewicz Research Network – Institute of Logistics

and Warehousing, Poznan, Poland

• PhD Péter Szikora, Keleti Faculty of Business and Management, Óbuda University,

Budapest, Hungary


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CONTENT

PART A – Core Management Skills

INTRODUCTION ................................................................................................................. 10

1. Organisational design .................................................................................................. 12

1.1 Division of labour .................................................................................................. 12

1.2 Division of power ................................................................................................... 14

1.3 Coordination.......................................................................................................... 16

1.4 Configuration ......................................................................................................... 17

1.5 Deciding on organisational structures.................................................................... 19

2. Organisational processes and their evaluation ............................................................. 22

2.1 Value creation in the organisation ......................................................................... 22

2.2 Organisational processes ...................................................................................... 24

2.3 Value chain ........................................................................................................... 25

2.4 Decomposition ...................................................................................................... 27

2.5 Efficacy Indicators ................................................................................................. 28

3. Influencing others ......................................................................................................... 32

3.1 Trait-centered approach ........................................................................................ 32

3.2 Decision-based approach...................................................................................... 33

3.3 Personality-centered approach.............................................................................. 35

3.4 Motivation ............................................................................................................. 39

4. Organisational goals and their measurement ............................................................... 43

4.1 Measuring organisational performance ................................................................. 43

4.2 Fairness ................................................................................................................ 45

4.3 Goal setting theory ................................................................................................ 46

4.4 Management by Objectives ................................................................................... 47

5. Situational leadership ................................................................................................... 49


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5.1 Classical school .................................................................................................... 50

5.2 Classic era in America .......................................................................................... 50

5.3 Mechanisation and industrial production ............................................................... 52

5.4 Classical era in Europe ......................................................................................... 53

5.5 France ................................................................................................................... 54

5.6 Germany ............................................................................................................... 56

5.7 Contingencialist approach ..................................................................................... 57

6. Groups in the organisation ........................................................................................... 62

6.1 Group dynamics .................................................................................................... 63

6.2 Motivation ............................................................................................................. 64

6.3 Group Roles .......................................................................................................... 65

7. Communicating in the organisation .............................................................................. 67

7.1 The direction of communication............................................................................. 67

7.2 Effective communication ....................................................................................... 69

7.3 The forms of communication ................................................................................. 70

7.4 Nonverbal communication ..................................................................................... 71

7.5 Emotional communication ..................................................................................... 72

7.6 Emotional work ..................................................................................................... 74

8. Change Management ................................................................................................... 76

8.1 Analysis of the organisational environment ........................................................... 76

8.2 Change management strategies ........................................................................... 79

8.3 Change in leadership tactics ................................................................................. 82

8.4 The process of change management .................................................................... 83

1. The Role and Principles of Financial Management ....................................................... 91

1.1 Strategic Financial Management ........................................................................... 92

1.2 Operating Financial Management ......................................................................... 93

2. Financial Statements, Cash Flows and Financial Ratios .............................................. 94


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2.1 Structure of Financial Statements ......................................................................... 94

2.2 Cash Flows ........................................................................................................... 96

2.3 Analyzing Financial Ratios .................................................................................. 101

3. Intrinsic Value ............................................................................................................ 104

3.1 Annuities ............................................................................................................. 106

3.2 Perpetuities ......................................................................................................... 107

3.3 Different Compounding Periods .......................................................................... 108

4. Capital Budgeting Decisions ...................................................................................... 110

4.1 Selecting Independent Projects ........................................................................... 111

4.2 Selecting Mutually Exclusive Projects ................................................................. 113

5. Project Cash Flows .................................................................................................... 115

5.1 Forecasting Capital Budgeting Cash Flows ......................................................... 115

5.2 Uncertainty in Project Cash Flow Forecasts ........................................................ 117

6. Financial Planning ...................................................................................................... 121

6.1 Financial Forecast ............................................................................................... 124

6.2 Long Term Financial Planning ............................................................................. 126

7. Business Financing .................................................................................................... 128

7.1 Sources of Capital ............................................................................................... 128

7.2 Capital Structure and its Cost .............................................................................. 131

8. Working Capital Management .................................................................................... 135

8.1 Cash Conversion Cycle ....................................................................................... 136

8.2 Managing Trade Receivables .............................................................................. 137

8.3 Cash Management and Working Capital Financing ............................................. 138

9. Inventory Management............................................................................................... 143

9.1 Monitoring and Ordering Systems ....................................................................... 144

9.2 Formal Inventory Models ..................................................................................... 146

10. Pricing and Costing ................................................................................................ 149


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10.1 Determinants of Demand .................................................................................... 151

10.2 Product Costing .................................................................................................. 152


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INTRODUCTION

This book aims primarily at students and practitioners of Logistics and Supply Chain

Management, providing them with the relevant knowledge base in the domains of Management

and Economics. It may also help prepare for the European Qualification Framework Level 6

(European Senior Logistician) candidate qualification as defined by the European Logistics

Association. Essential topics from its Core Management Skills are included in Part A, while those

from Business Principles module are included in Part B.

Part A encompasses a wide variety of topics on organisational design, processes and their

evaluation. It focuses mainly on the soft elements of the organisations, such as communication,

motivation, leadership; and the combination of them, Management by Objectives.

Part B on the other hand describes the basic approaches connected to the financing

of businesses. From a strategic, as well as from an operative point of view, including cash-flow

management, costing, pricing, financing and budgeting decisions as well as their planning.

The book is complemented by the teaching materials students obtain during seminars,

as well as the online simulation, which, in the form of gamification supports the understanding

and obtaining of relevant necessary knowledge, skills and competences.

Additional resources might be useful for a successful preparation for the European Senior

Logistician exam, especially those listed in the references part.


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PART A – Core Management Skills

Kornélia Lazányi


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1. ORGANISATIONAL DESIGN

The concept of the company

Enterprises are micro-economic systems - of personnel and financial assets - in the

market environment that have their own goals and for this goal they continue to operate

The purpose of a company is to maintain itself; in the broader sense to:

• increase its efficiency,

• Increase its effectiveness.

The economic purpose of a company is to gain profits, which can be realised in the form of:

• income and / profit,

• money,

• increasing assets.

Most companies operate as organisations whose general characteristics are:

• a group of two or more people,

• that works together for a common goal,

• exert coordinated efforts to reach the organisational goal,

• has rules and structure regulate their activities.

One of the most important characteristics of companies is the organisational structure. Its task

is to divide actions rationally and logically between departments and individuals. The basic

features of organisational structure are division of , division of power, coordination

and configuration.

1.1 DIVISION OF LABOUR

The division of labour means dividing a larger task to smaller tasks and at the same time

assigning them to organisational units. While, before the first industrial revolution, the division

of labour was merely a characteristic of prentices and only lasted till the end of apprenticeship

(when they have learned how to deal with a ll the tasks related to their profession) after the


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industrial revolution, with the increasing complexity of the tasks and the mass production,

the division of labour became increasingly important, because one worker alone was not able

to perform each job efficiently. The essence of division of labour is that each unit

of the organisation (whether class, group or individual) deals with tasks best befitting to his/her

the comparative advantages and does not produce a whole product or service but just one part of

it.

Work can be divided along multiple principles. The assignment can be done by function,

product (group), consumer, region principle.

If we look at a car repair’s work, a functional division of labour would mean that while one

employee only changes tires, the other repairs engines, the third is responsible for polishing,

and so on.

Product based division on the other hand would choose the staff based on what they are

preparing. One is repairing cars, the other one trucks, and the third motorbikes.

The division of labour according to the regional principle is necessary, if the organisation

has several locations (there is a repair workshop in Budapest and another in Miskolc). In such

cases, it does not make sense to deliver (semi-finished) products between them and use

a functional or product-based division of labour, but both repair stations will organize their work

independent of each other.

The division of labour on the basis of customers is similar to the regional principle, though

- although production is on the same site - but the "distance" of customers does not allow them to

be served with the same product group. In this case, the distance between buyers indicates the

difference between buyers' choices and preferences. For example, it is not possible to sell

traditional shell and coating for those interested in tuning cars.

As it can be seen from the above examples, the principles of division of labour essentially

affect organisational processes. It is therefore important that you choose it properly. The answer

can be that the division of work in organisations can not only be organised along one sole

principle (one-dimensional organisation), but it is also possible to combine different work-sharing

principles.

If the division of labour takes place along two different principles - the work of the given

units is determined at the same time by two principles in the division of labour - it is possible to


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speak of a two-dimensional organisation, but there are also more (multidimensional)

organisations.

1.2 DIVISION OF POWER

The decisive element of organisational structure is the distribution of power between

organisational members (individuals and units). In relation to the allocation of powers, rights

related to decision making, commitment, agreement, negotiation, management, execution and

control should also be taken into account. The sharing of powers is ideally done

on a competence basis.

When designing a system of division of power, it is worth distinguishing between

decisions dealing with strategic or operational issues. Strategic decisions that determine

the organisation's long-term operation and competitiveness are generally dedicated to higher

levels of organisational hierarchy, while it is desirable to delegate operative decisions that allow

the management of day-to-day problems to lower levels of the organisation closer to the place

of emergence of the problem.

If strategic and operational decisions are made by people at the top of the organisational

hierarchy, the organisation is considered centralized. However, if some of the decision-making

powers - typically related to operational tasks - are delegated to the lower hierarchical levels

of the organisation, the organisation shows decentralized features.

Centralisation and division of powers may also be influenced by organisational size.

In smaller, simpler organisations where the depth of division of labour or the size of the

organisation does not justify a complex division of responsibilities, organisational units can only

get instructions from a single leader. From the point of view of subordinate units, such a system

is called a single line organisation. The advantage of such a form is the clear subordination and

superiority, as well as clear, straightforward relationships. However, with increasing

organisational size, however, the chain of command becomes more and more complex, longer

and slower, coordination tasks become more and more overwhelming for the higher ups.

In addition, in mechanistic, rarely, or only slightly changing organisations, personal dependency

is often formed between representatives of hierarchical levels independent of competences.


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If the organisation is bigger or the division of labour takes place over multiple dimensions,

the power relations become more complex - such organisations are called multi-line

organisations. They are characterized by high degree of specialisation and direct instruction

and information. The disadvantage of the system is that it is difficult to identify the responsible

persons when it comes to problems - since one unit has more than one manager at a time.

It is therefore difficult to connect competences with responsibilities. Multi-line hierarchy can be

a source of many conflicts, which, if tied to people, do not support organisational performance.

It is an important rule that one-dimensional organisations can also have multi-line

management, but for multidimensional organisations there cannot be a single-line leadership

because at least one hierarchical chain is built up along each dimension.

Coordination tools that coordinate the work of organisational units are important elements

of organisational structure. Coordination is nothing more than a targeted form of communication.

Accordingly, the direction may be vertical and horizontal. Coordination of organisational

processes in several ways feasible. The most obvious co-ordination tools are elements of the

organisation's written rules - technocratic solutions. These include different rules, policies,

procedures, or plans (strategic, operational, functional) and programs. The advantage of these

forms of coordination is that it has traces and can be retrieved. The instructions are clear to all

parties and can be communicated simultaneously with more than one person. While

organisational strategy might not be the best to communicate organisational goals to its members

– owing to its lengthy and more detailed nature – there are other means for such purposes, like

organisational mission and vision.

In order for an organisation to operate on a long-term basis, for its leaders to have an

easily communicable version of their strategic thinking organisations often use vision statements.

Vision seeks to outline where the organisation is headed and what values are guiding that

journey.

It introduces and simplifies the attempted future what the organization exists to achieve.

The vision statement is based on the company’s core beliefs and values that remain constant

regardless of the business environment, the profit level, or other external factors. It is the basis

of organisational culture.

If a strategic leader wants to go beyond the vision, however, by making a clearer

delineation of organisational goals and how the well-articulated and wide communicated vision

will be accomplished, he/she can create a mission statement. Like the vision, the mission also


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communicates the organization’s purposes; it is a way to express the vision in practical terms.

What does the organization exist to do? What are the objectives?

Vision and mission are basic form of articulation of strategic thinking, hence, they can be

used well, for communication purposes. However, in order for them to really influence

organisational processes and people within the organisation, they should be concrete and include

goal-oriented language. It should include measurable objectives. Every person within the

organization can evaluate whether his or her own activities will serve to help the company

achieve its mission, (for further details see Chapter 4.4).

The importance of mission and vision statement is clearly indicated by them being an

unavoidable part of not only internal communication, but every business plan be it prepared for

establishment, organisational change or loan retrieving purposes. (For the structure of a business

plan recommended by Forbes, see Appendix 1.)

1.3 COORDINATION

Tools that coordinate the work of organisational units are important elements

of organisational structure. Coordination is nothing more than a targeted form of communication.

Accordingly, the direction may be vertical and horizontal. The coordination of organisational

processes can be realized in several ways. The most obvious co-ordination tools are elements

of the organisation's written rules - technocratic solutions. These include different rules, policies,

procedures, or plans (strategic, operational, functional) and programs. The advantage of these

forms of coordination is that they have traces and can be retrieved. The instructions are clear

to all parties and can be communicated simultaneously with more than one person.

Person-oriented solutions, on the other hand operate along the organisational culture

and value system. Their aim is to support the identification of organisational members

with organisational culture. Such practices can be the methods of conflict management

or leadership training and selection. The advantage of this form of coordination is that it does not

only act on a cognitive level, but it also provides guidance - not just for pre-programmed

decisions, but also in individual situations. It is a disadvantage that it can only be influenced over

a long period of time and is difficult to modify. This form of coordination is integrated into

the organisational memory.


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The third form of co-ordination mechanism is that of structural apparatuses, which have

an effect through structuring an organisation in a given way. Their aim is to ensure

the consistency between managerial decisions and the functioning of organisational units.

Such solutions include ad hoc and permanent committees, project teams and product

management systems. It also includes the (mainly vertical) communication paths stemming from

division of labour, as well as matrix-type organisational solutions.

1.4 CONFIGURATION

Configuration is a secondary structural feature. It is created through the other three features

together. It is a visualisation technique, which makes the organisation's structure easier

to understand. Its features:

• hierarchical depth of the organisation (number of hierarchical levels)

• organisation's breadth-of-structure (number of subordinates directly belonging to a leader)

• size of organisational units (number of employees belonging to the given unit)

In the configuration, it is clearly indicated how a given organisation applies the division

of powers. The advantage of linear organisational solutions is that they are simple, easy to

review, subordination is clear, and their cost of designing and running is low. The two most

common forms of the single line - linear - organisations are the functional (function - based

division of labour) and the divisional (product or market - based division of labour).

Figure 1. Schematic graph (configuration) of a single-line organisation

Source: own study

1. level

2. level

3. level

Horizontal enlargement

Service path


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It is an easy to create organisational configuration that can be expanded in width

and depth and can easily outsource unnecessary activities / units. Such configuration is well

suited for small organisations with simple, homogeneous tasks, under stable operating conditions

with low innovation constraints. A large number of employees can be well coordinated with help

of it. The weak point of such structure lies in its nature. Because of the unequal division

of responsibilities, the top management is heavily laden and organisational communication

is happening only through formal channels and service paths. This makes it difficult

for the organisation to react to environmental changes.

Outsourcing can have a significant impact on an organisations bottom line. It can reduce

overheads, bring fresh expertise to the business, and free up resources for innovation and other

tasks. Nonetheless, before making the decision whether or not to outsource certain activities,

the strategic importance of the task has to be considered. Does the task in question serve

as a competitive advantage? How important is the task in the everyday operations of the

organization? Tasks of strategic importance that have a big impact on operational performance

have to be retained, and their organisational units incorporated to the organisational structure.

But not all tasks are like this. Some tasks are strategically important, but contribute little

to operational performance, so could be outsourced safely to a trusted partner, (in such cases

strategic alliances are supposed to be formed). Tasks, that are neither strategically important, nor

have a decisive impact on company performance have to be analysed from cost/benefit aspect

but can freely be outsourced.

One of the most common configurations of multi-line organisations is the matrix

organisation. The division of labour in this case takes place along two separate dimensions, and

the division of powers is multi-line.


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Figure 2. Schematic picture of a multiline, multi dimension organisation

Source: own study

Because of the multiline nature this configuration is characterized by multi-faceted nature.

It adapts more easily to changes in the organisational environment, and it manages complex

tasks that require significant innovation. Nevertheless, the disadvantage of multi-line

management is that it generates rivalry and power struggles between various managers.

In connection with common decisions stalling and passing on responsibility is a typical behaviour.

Another problem is that common decisions are made much slower than individual decisions

in linear organisms, so the organisation responds slowly to crisis situations.

1.5 DECIDING ON ORGANISATIONAL STRUCTURES

The organisational structure can optimally manage organisational processes when not

only taking into account the features of the organisation, but also that of the organisational

environment. We consider an element of the environment every condition, effect, and factor

Development R&D director

Production Director of production

Commerce Sales director

Corporate governances

product

(head of unit)

product

(head of unit)

product

(head of unit)

GOVERNING BODIES

A

B

C


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affecting, limiting and defining the behaviour and activity of the organisation and its constituent

individuals or groups.

The organisational environment is decomposed into spheres that interact with each other.

• macro environment - the widest system of relevant environmental factors

• micro environment - the industry environment of the given products / services

• operating environment - all elements that have a smaller or greater impact on the

organisation's operations and which are influenced more or less by organisational

operations

• internal environment - the basic features of the organisation

The strategically organized organisational structure therefore focuses on the corporate

environment and builds on the evaluation of competition and the relevant market rather than

focuses on the organisation alone and builds on the results of the past.

Figure 3. The spheres of the organisational environment

Source: Based on Burns, Stalker (1961)

In industries with fast market and technological changes, it is necessary to develop

organic organisational forms, while in the industries with stable markets and unchanged product

basket, it is mostly reasonable to create mechanistic forms. In addition, the environment may also

Macro environment (economic, social, political, technological, ecological,

regulatory environment)

Micro environment (dealers, buyers, potential market entrants,

producers of substitutes, competitors)

Operating environment (the company's strategic teams,

creditors, suppliers, buyers, labour, etc.)

Internal environment (financial, technological, human resources,

locations, culture, organisational structure, etc.)


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affect organisational system of distribution of power, as organisations in a volatile, precarious

environment are shall be more decentralized, while more predictable industries are characterized

by more centralized organisations.

MECHANISTIC STRUCTURE ORGANIC STRUCTURE

high degree of specialisation, programmed behaviour, routine tasks

the influence is based on the expertise

formalisation, instruction chains more horizontal rather than vertical

communication

centralisation decentralized decision-making

rigid hierarchy flexible, adaptive structure

tight control, supervision participative leadership

Figure 4. The characteristics of different structural forms

Source: Based on Burns, Stalker (1961)

Knowing these consistencies is important because adaptation is necessary for all long-term

viable organisations. Adaptation should not only appear in the organisation's strategy, but the

organisational structure must also support efficient and effective organisational behaviour.


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2. ORGANISATIONAL PROCESSES AND THEIR EVALUATION

2.1 VALUE CREATION IN THE ORGANISATION

The organisation is a system that has inputs (materials, money, human resources)

a transformation process (technology) and outputs (goods and services). This conversion

process is called a value-creating process in the economic language. The value-creating process

is therefore the acquisition, management and use of resources, to create value for the consumer.

In order to ensure value creation with a proper output, the organisation has to answer five basic

questions:

• For whom? Who is the target group of the organisation, what kind of markets

and submarkets does it want to target?

To answer this question, it is necessary to determine the needs of the selected target group

(necessity, which motivates purposeful action); of which some are latent, and some are already

formulated, which products, services they are willing to pay for (demand), and which ones they

would not only want but can buy (consumer demand).

• What? Which product, service (or combination) does it want to sell on the chosen market?

To answer this one needs to be aware of the fact that consumers want a product they value.

However, value can be a value of use (the set of properties of the product that makes it fit for the

claim), place value (the product's feature to be available in space, accessible to the buyer), time

value (the product is close to the moment of production of the claim time availability), and

property value (right of disposal over the product).

• How? How it wants its product and service to be produced; what kind of organisational

structure, infrastructure, technology, and human resources are needed for this?

Defining the organisation's products and services from the point of view of corporate value-

creating processes, the corporate value chain is the link of corporate activities creating corporate

value. It usually involves intra-corporal systems and processes. The realisation of the material

processes of the value chain, which is usually understood between companies, is called a value

chain.


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• How much? At what price does it want to sell the product, service, and what price

the selected target segment is willing to pay for it?

Pricing may be based on product and service costs, in which case we are talking about

product-oriented pricing, but we can also start from the demand for solvency when market-

oriented pricing is applied. independent of the chosen pricing method, the purpose of the

organisation is to maintain itself and to realize profits, so the total cost should be lower or (at least

as much) as the total revenue over the long run.

• When? When can it launch the product or service; within what timeframe can profit be

realized for the organisation?

Demand for products, services are changing in time. It is strategically important for the

organisation to target a market that is in an expanding phase, to create a product or service for

which demand can be forecasted, to offer them at a price at which demand is/can be sustained

on a long run. For this the product life-cycle, as well as the S curve of innovation shall be tightly

monitored.

Figure 5. The life-cycle and innovation curve of products and services

Source: own study

Time

S Curve 100%

Life-cycle

Innovators

2,5%

Early adopters

13,5%

Early majority

34%

Late majority

34%

Laggards

16%


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The whole set of elements of the system does not form a system without the connections

between elements. The system is therefore more than the sum of its parts. In most companies,

there is also a feedback between outputs and inputs that allows the organisation to integrate

feedback from the organisation's environment into organisational processes, and the necessary

intervention.

2.2 ORGANISATIONAL PROCESSES

While the structure of the organisations consists of units and their relationships, in case

of systems, we must take the organisational processes into account. Analysis of processes

enables the assessment and evaluation of organisations. Input-output relations are also relevant

for processes the same as for organisations. All processes need some kind of resources (human

work, energy, raw materials, information) and after a transformation process, each creates

an output is made available to the environment. Organisational processes most often receive

both their inputs from within the organisation - from other organisational processes - and create

outputs that are required by other units of the organisation; but there are also cross-border

processes, such as sales, or front-end in case of service providers (the moment of providing

the service).

Figure 6. Organisational processes

Source: own study

Input processes

Transformation

processes

Output

processes

Regulation


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Organisational processes are built upon each other. Their consistency and organisation

are one of the cornerstones of corporate competitiveness. Processes can contribute to the

organisation's competitiveness in two ways. Low-cost, cost-efficient, fast-run, error-free

processes enhance organisational efficiency, while processes generating customer satisfaction

and loyal customers that help to improve the organisation's environmental fit improve operational

efficiency.

The organisational processes can be divided into two parts from their customers’ point of

view. For some of the processes the customers are non-organisational members. Processes

reaching beyond the organisational boundaries are commonly called key processes. However,

most of the processes are within the organisation - which can be labelled supportive processes.

2.3 VALUE CHAIN

Processes can be distinguished not only by their customers but also by their purpose.

While operative processes are related to the daily routine of an organisation, management tasks

relate to planning, organizing, managing and controlling operative processes.

This is well depicted in the value chain model of Michael Porter, in which the processes

associated with organisational core activity are depicted sharply from the supportive processes

that enable them to emerge. The model is basically created for production companies,

and although the structure of service companies is often very similar to their production

companies, we can discover fundamental differences at system level.


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Figure 7. The value chain model of organization

Source: Based on Porter (1979)

With the help of the model, it is easy to understand that the value chain is nothing more

than a value-linking of corporate systems and processes that is designed to create a product that

meets the needs of consumers.

For production companies, the core processes are related to the creation of the product.

The operations in their case includes all the processes that will make (transform) the raw material

ready for use. Such processes are:

• the supply,

• inbound logistics,

• transformation processes,

• outbound logistics,

• promotion of marketing and sales,

• sales or maintenance and warranty services.

Supportive processes are those systems that enable the realisation of the core processes.

The importance of these systems for corporate strategy is not less than that of core processes,

Core processes

Procurement

Technical development

Human resource management

Organisational infrastructure

Inbound logistics

Operations Outbound logistics

Sales and marketing

After sales services

Sup

port

ive

pro

cesses


27

in fact, very often, their added value is decisive for long-term successful operation. This group

includes:

• service processes (such as maintenance),

• management and organisational processes,

• strategic management processes,

• development and modernisation.

The value chain analysis helps to identify the interconnected elements involved in the

production of the products. It analyses how and to what extent each item produces added value

and helps to figure out how many enterprise resources those elements require. Value-chain

based assessment of systems can be the starting point for examining industry trends

and searching for industry benchmarks. What is more, the value chain approach of companies

enable the use of non-industry best practices as a functional benchmark and the incorporation

of them into corporate practice.

2.4 DECOMPOSITION

Organisational processes can be divided into activities that - like the processes and the

whole organisation - have input and output (output) the transformation between the two is the

activity itself. Accordingly, the processes presented above are nothing but the coherent chains

of activities that are defined in space and time and are intended to satisfy a need or to solve

a problem.

The term activity can refer to an arbitrary transformation, it can be a simple, easy-to-

automate task that does not require thinking, but it can also refer to complex physical

and / or mental tasks.

Although the organisational structure, by identifying the dimensions of work

and competence sharing, and by examining systems, by trying to evaluate the role of processes

in the value chain, is to support the work of corporate decision makers, the diversity

of organisational units and their processes often justify activity-based decomposition. When

decomposing organisations, it is important to define units that fosters that:

• a well-structured organisation is created,


28

• optimize the execution of key processes,

• improve operational efficiency.

One important purpose of decomposition is that the performance of units created on the basis

of activity can be well identified and measurable. The purpose of decomposing is therefore

to create units of responsibility and accountability that can be defined for each unit

of the configuration - whether it is a group or, in extreme cases, a single person (who has

distinctly separate tasks and responsibilities from the others) - to determine the method

of measuring and monitoring the tasks delivered by the units.

To achieve this goal, different decomposition logics can be used by the organisation.

When functionally decomposed - as in the case of functional division of labour - the same

professional activities are organized into units, while decomposed on the basis of the division

of labour, activities are decomposed along the individual product groups, customer circles

or regional units. The logic of the process-oriented decomposition is principally different from the

logic of the decomposition along the division of labour. Here the chain of activities in input-output

relation are the basis of the internal logic of decomposition. If in an organisation the demarcation

of material and information processes is important, material / information-based decomposition

may also take place.

Decomposition can also help to distinguish strategically significant (eg core competence)

and less significant activities. In such cases we are talking about strategical decomposing

and entities created along these principles are called strategic business units (SBUs).

For strategic business units, it is particularly important that their activities are well identified and

measurable.

2.5 EFFICACY INDICATORS

Organisational operation and organisational processes can be evaluated from two

perspectives; efficiency and effectiveness. A process is effective if you can achieve the goal

of the process in a shorter time, with fewer errors or with fewer inputs. However, efficiency

is a more complex phenomenon. We consider a process effective when it enables

the organisation to solve cardinal issues / problems when it generates value for the organisation

or allows it to create a higher consumer value than before.


29

Based on the fact whether inputs, outputs, process efficiency, or possibly other activity

dimensions can be best quantified an SBU can be regarded a cost, revenue, profit or investment

centre. The characteristics of the given units are summarized in the table below.

TYPE UNIT OF CONTROL PURPOSE OF CONTROL INCIDENCE OF UNITS

COST Costs and Expenses Increase efectiveness Reduce costs without

reducing outputs

Units with difficult quantizable outputs e.g.

administrative departments

REVENUE Realized traffic Improve efficiency

Increase sales volume

Units controlling processes beyond

organisational boundaries e.g. sales

divisions

PROFIT Profit Improve efficiency

Management of resources Divisions of divisional

organisations

INVESTMENT Return on investment Improve efficiency

Extensive fiscal management

Subsidiaries or individual organisations of holding organisations

Figure 8. Basic types of Strategic Business Units

Source: Based on Govindarajan (1986)

In cost centres, budget planning is typically carried out where the planning is based

on the budget of the previous year. As a result, the organisational unit's budget often separates

from the amount of tasks to be borne by the unit. In order to avoid such situation, it is best to

apply a nil budgetary cost planning every 3-5 years when the organisation attempts to quantify

some of the tasks performed by the unit (e.g. through the average working hours per week)

and determine the budget appropriation for the department. In the case of cost centres, the head

of the centre has a relatively large scope to use the costs that are available to him,

but the prerequisite for a rational allocation is to monitor and evaluate in some way the efficiency

and effectiveness of activities with difficult measurable outputs. Cost-based accounting can

also be applied to organisational units where the relationship between inputs and outputs is well-

known - one unit of output can be generated from a given amount of inputs.


30

The establishment of revenue centres is justified when the head of a given organisational

unit cannot influence either the unit cost of inputs or the unit price of outputs, so the revenue from

the products / services sold by the unit is the best indicator of the effort of the organisational unit.

The profit centre is the complete opposite of such small range decision systems. In profit centres

the leader can influence the cost / price of both the inputs and the outputs. The head of the

centre can not only choose the inputs, but may also make product / service mix decisions. The

unit's activity can be measured well, and the performance of the unit can move not only in

positive, but in negative range as well. What's more, a deficit (loss-generating, negative profit-

making) organisation can measure its own efficiency and effectiveness change in the light of its

realized results.

Investment centres are the last kind of accountability units. Their autonomy is the largest

of all types of business units, since they can not only decide on their inputs and outputs, but

decisions on investments required to increase efficiency also fall within the competence of the

head of a department. Therefore, the activities of the centres are characterized not only by short-

term profitability but also by its long-term sustainability.

Conversion of units of the organisations into units of responsibility and accounting is often

not a simple or straightforward task. For multiple units, activities can be evaluated in multiple

ways. For this reason, it is the responsibility of the top management to determine the

classification of different business units and to delegate the decision-making powers necessary

for managing it to the head of that unit - decentralize.

Organisational performance from a strategic point of view, however, cannot only be

described by financial indicators. There are other elements, that have to be evaluated and

monitored for long term success, such es motivation or commitment of workers. To incorporate

further aspects, Robert S. Kaplan and David P. Norton (1996) have developed a balanced

scorecard (BSC). Besides the ever-important financial aspects the costumers are also viewed as

strategic stakeholders (for further details see Chapter 4.1 as well). BSC also views organizational

performance through the lenses of the quality and efficiency related to business processes,

hence processes are also a crucial part of the system. Last but not least, organisations not

reacting, or just lagging behind industrial changes cannot flourish, hence learning is also

incorporated into BSC. This aspect explores performance from the point of view of human capital,


31

infrastructure, technology, culture and other capacities that are key to organisational change and

development.

Figure 9. Balanced scorecard

Source: LeanSixSigmaBelgium.com

FINANCIAL

To succeed financially, how should the entity

appear to their stockholders?

LEARNING AND GROWTH

To reach its vision,

how is the entity likely to sustain its

capacity to change and improve?

CUSTOMER

To reach its vision, how should the

entity appear to their customers?

INTERNAL PROCESSES

To satisfy their

stakeholders, what internal processes should the entity

master?

Vision and

Strategy


32

3. INFLUENCING OTHERS

The international literature distinguishes between two different types of management.

The impact on people is rather called leadership (leadership of people), the impact

on organisations is labelled management (management of organisations). The leadership

is therefore an element of managerial activity that deals with the human resources, mobilizes

the organisational members to achieve organisational goals. It is an ability to influence a group

to reach organisational goals. Leadership is a way of management, where the leader does

not lead directly, but rather indirectly led effects his/her subordinates, uses indirect instruments;

does not command but influence. Accordingly, leadership style is closely related to motivation -

it is based on the understanding of what motivates people.

3.1 TRAIT-CENTERED APPROACH

The search for the ideal leader has not lost its relevance since the formation of human

societies. While in many societies the quest for the perfect leader was based on researches into

a range of physical characteristics (Ancient Egypt - high, flat forehead; or as in Ancient Sparta -

the physically improbable babies were dropped from Taygetos, while the strongest were chosen

as leaders), modern-day organisational science focuses on mental and emotional qualities

instead of physical attributes. Numerous studies have tried to determine what distinguishes

a manager from an employee and the effective leaders from ineffective ones.

From the trait - centred theories the approach that considers the emotional intelligence

of leaders as a cardinal feature has not lost its relevance to the present. The emotional

intelligence closely correlates with the ability to influence and thus gives the essence

of leadership. People with emotional intelligence are able to create a magnetic field that gives

them emotional appeal, so they often have an ever-growing social network and emotional support

system, they are more willing to accept themselves, and more easily enforce their will.

According to Mayer and Salovey's ability-based approach, emotional intelligence is the

ability to comprehend, perceive, evaluate and express emotions, raise them to the cognitive level,

understand them and their information content; and the ability to regulate the emotional


33

and intellectual development of an individual. So, it is a set of cognitive abilities that allow the

identification, realisation, correct use and articulation of emotions.

Others consider emotional intelligence as a relationship of abilities and personalities that

allow the perception and treatment of emotions. The most commonly used is the model

of Reuven Bar-On (1944- ), in which emotional intelligence is depicted as the emotional,

personal, social and survival dimensions of intelligence, which is often more important

for the daily survival than the traditional cognitive aspect of life. Emotional intelligence is a tool for

understanding ourselves and others, for relating to others, for instant adaptation to environmental

change and a means of long-term survival. Emotional work means nothing more than 'common

sense' and the way in which the surrounding world is treated.

Bar-On has divided emotional intelligence into 5 components.

• intrapersonal: emotional awareness, self-awareness, self-validation, self-realisation

• interpersonal: empathy, ability to create and maintain social relationships

• adaptation: problem solving, feasibility study, flexibility

• stress management: stress tolerance, impulse control

• general mood: optimism, happiness

Daniel Goleman (1946- ) has another point of view regarding emotional intelligence.

In his interpretation, emotional intelligence embraces a wide range of emotional attitudes and

competences ranging from motives, personal characteristics to learned abilities.

The 25 competences he defined were divided into 5 main groups: self-awareness, motivation,

self-regulation, empathy and social skills. He thinks that all practical, work-related skills are based

on these five competencies, and emotional intelligence is the potential to enable the mastery

of them.

That is why it is particularly important for leaders to have a high emotional intelligence.

3.2 DECISION-BASED APPROACH

However, in many cases it is not sufficient for managers to have high emotional intelligence if the

subordinates (perhaps because of their lower level of emotional intelligence) do not feel that they

are not mere servants of the organisation, but also important parts of it. This momentum has


34

been put into the centre of the research of decision - centred leadership theories, which typify

the management systems according to the process of decision-making and focus on how the

leader makes the decisions and what kind of the participation in decision making he/she allows

the subordinates. This issue, in the light of the structural features previously described, is easily

linked to the power system of the organisation, with its centralisation or decentralisation.

Kurt Lewin's (1890-1947) vision greatly simplified the situation of the leader. According

to his theory, either a leader involves the people concerned and decides democratically or makes

all the decisions alone and is considered autocratic or, - and this is not really a managerial

behaviour - leaves the organisation and its members alone in the decision-making situation

acting laisseiz-faire.

The autocratic style is characterized by authoritarianism, centralized power. The leader

dominates the group's activities. He decides alone on all relevant issues, holds strict discipline,

evaluates on a subjective basis. On the other hand, the functioning of the decentralized system

is based on democratic cooperation which is stemming from the common goals

of the organisational members. The task of the manager is to increase the participation

and activity of group members in decision-making situations and to objectively evaluate

performance.

The laissez fair system is difficult to imagine from the point of view of division of power,

as here the decision is not delegated to the lower level of the organisational hierarchy

by deliberate division of power. The system is extremely liberal, often leading to anarchic

operations, where the delivery of work is uncontrollable. The leader in such cases is not a real

leader, rather a passive participant in the organisation. He/she does not initiate, does, or only on

request, assist the work of the organisational members.

Rensis Likert (1903-1981) did not integrate the latter "leadership" style into his typology.

He was rather focused on the investigation of autocratic and democratic systems, which,

in his view, exclude each other. As a result of his research, he developed a four-tier leadership

typology, the only factor of which still being the degree of involvement of the subordinate

in the management process, but he further refined the former binary system, taking into account

the leaders's attitudes.

In his system, the exploitative autocratic leader is distrustful, motivating the employees

with threats, punishment (very rarely reward). He/she centralizes decision and control, uses


35

downward communication. In contrast, there may be a different type of centralized system

in which the leader is benevolent. In such situations, the leader has some confidence in the

organisation's members and their qualities. He/she occasionally demands the opinions of the

subordinates, and allows them to decide on smaller matters, but always controls the decision on

his/her own. In such organisations the direction of communication is still dominantly downward.

The leader - opposed to the exploitative autocratic system - motivates mostly by reward.

The next level of confidence in the subordinates is consultative leadership. The leader

does not only involve a wide range of employees in the preparation and decision-making process

but seeks collective decisions on global issues. In such systems, communication works well

in both directions. The employees are motivated not only by reward but also by the participation,

since their ideas are incorporated into the organisational reality.

In the interpretation of Likert, the organisational form of total trust is the participative

leadership. Team members are not only involved in preparation and decision-making, but also

in targeting goals, defining performance indicators, and evaluating performance. The leader

requires the opinions and ideas of the subordinates, trusts their decisions. Subordinates are

evaluated and motivated by both financial and non-financial remunerations.

3.3 PERSONALITY-CENTERED APPROACH

The two systems, Lewin and Likert, clearly show that division of responsibilities is a very

important structural dimension and influences both the leaders and the subordinates strongly.

Decision-centred leadership typologies, however, just like every model, present organisational

reality and leadership systems in a very simplified way. For this reason, leadership literature

turned to developing further investigative aspects, and instead of the centralized nature

of decisions the personality of the leader and his/her focus of attention became the focal point

of researches.

The researchers at the University of Michigan (Likert and Hemphill) have defined a one-

dimensional continuum between two leadership styles based on managerial attention. The job-

centred style has scales measuring two job-oriented behaviours of goal emphasis and work

facilitation. In their system, the job - centred leader takes the time to break down, organize

and control tasks because he/she is primarily interested in organisational performance. During


36

his/her work, he/she builds on legitimate, rewarding and coercive powers. On the other hand,

the employee-oriented leader concentrates on the social atmosphere of the working group,

creates a cohesive group, builds on group cohesion, because it is important for him/her that

the employees shall be satisfied. He/she constantly works on settling or even preventing

conflicts. For him/her, the task is only of secondary importance. His/her leadership style

is characterized by the division of power. The employees are motivated by the possibility

of participation and development. The employee - centred style focuses on two employee-

oriented behaviours: supportive leadership and interaction facilitation.

In the model of the University of Michigan, the two orientations are the two endpoints

of the leaders’ attention. A leader can focus his/her attention completely on the good relationship

with his/her colleagues or the task, but not the both of them at the very same time. However,

the Ohio University model has the potentiality of the “perfect leader”, the leader can create

a combination of focusing on the structure and paying attention to the subordinates.

The interesting point of the model is that the two types of attention are not considered as two

endpoints of a continuum but as separate dimensions. Accordingly, the two dimensions indicate

twofold attention as feasible. According to the system, attention to one area does not entail the

relative neglect of the other area.

By using the terminology of the model, the leader who achieves high value in the initiating

structure dimension can work out the tasks, processes, mechanisms for the subordinates in detail

and prescribe what to do and how to do it. On the other hand, the high-consideration leader is

interested in the subordinates, seeking a friendly, trusting, supportive atmosphere, and is

responsive to the feelings and human problems of the subordinates. Another interesting feature

of the model can not only measure the attention of the leader, but also predict its impact on the

organisation, as exemplified in the following table.


37

Figure 10. The effect of the leader’s attention on the organisation

Source: own study

The model of the University of Ohio and that of the decision-focused approach are

synthetized in Robert Blake's (1918-2004) and Jane Mouton (1930-1987) leadership grid model,

which uses the utility curves known from microeconomics to indicate the leader’s impact on the

organisation. The two dimensions were labelled in this case concern for people and concern for

results. The design of the grid and the location of the utility curves suggest that a leader is

effective when paying maximum attention to both dimensions. The novelty of the grid approach is

that, while the earlier theories were designed to test and label the leader, the grid was designed

to point out the areas to be developed and to instruct the leader how to improve his leadership

style through trainings.

HIGH INITIATING STRUCTURE LOW INITIATING STRUCTURE

HIGH

CONSIDERATION

Good performance

Few complaints

Low fluctuation

Poor performance

Few complaints

Low fluctuation

LOW

CONSIDERATION

Good performance

Many complaints

High fluctuation

Poor performance

Many complaints

High fluctuation


38

•

Figure 11. Blake-Mouton managerial grid

Source: own study

The middle of the system is a compromising leadership style labelled “middle of the road

management” with the ideology of achieving good organisational performance by creating

a balance between maintaining the expected work performance and a satisfactory level

of employee morale at the same time. On the same utility curve, there is also a leadership style

of power-obedience and a people - oriented leadership style. Thus, we can state that the grid

entails the continuum designed by the researchers of the University of Michigan. The model,

however, continued to develop and integrated the idea developed of the "perfect" leader

developed by the University of Ohio, who received the team manager name in this system.

However, based on the decision-oriented - and, in particular, Lewin’s - theories the grid also

points out the leadership style, where the leader is not involved in organisational management,

which is well matched up with the laissez-faire leading style.

Whether it is trait, decision or personality - centred approaches, there is a single

conclusion in common. They all emphasize the importance of the human dimension

Authority-obedience

management

Team manager

Impoverished manager

Country club manager

Peo

ple

concern

Task concern

1,9 9,9

1,1 9,1

Middle of road management

U1

U2

U3

5,5


39

of leadership; even when they believe in the possibility of developing into a leader, and therefore

suggest leadership trainings for the process of becoming a perfect leader, or when emphasizing

the persistence of personality and the rigidity of attitudes, focusing on the selection of the ideal

leader. They do all this because leadership style can lead to increased organisational efficiency if

it increases employee motivation and satisfaction.

The 20th century management experts see the solution in transformational leadership,

in which, - as opposed to the former transactionalist approach where the employee does things in

exchange for certain benefits - the leader seeks to achieve his/her goals by creating and unifying

superior human goals and values. It transforms the workers' mindset and replaces former

suboptimal values (and attitudes) with a new value system.

Henry Mintzberg (1939-) made the same argument from the point of view of leadership

roles. He emphasised that, although leaders have traditionally a role in decision-making, such as

resource allocation, disruption or negotiation, the leadership's personal and information tasks are

also of cardinal importance. While the latter includes information gathering and distribution as

well as the role of a spokespersons, the most important role within interpersonal roles is that of

relationship-building and nurturing which underlines the importance of emotional intelligence

(already discussed in connection with trait - centred theories). This group also includes a wide

range of roles, such as that of the figurehead, along with public appearances and representation

of the organisation.

3.4 MOTIVATION

The relationship of the leaders and subordinates is cardinal for the organisational

situations. However, the organisational culture, the groups, and the incentive systems managed

by the organisation can be just as important. Employee satisfaction is determined by what

incentives the organisation uses and how it recognizes employee performance.

Motivation is the willingness to realize organisational goals. Willingness to achieve the

organisational goals that one can meet along with satisfying his/her own individual needs. It is an

urge to behave in a certain way. Leaders should therefore consciously seek to motivate their staff

members and not only to make them perform better, but also to increase their satisfaction with

work and business.


40

Figure 12. Schematic model of motivation in organisations

Source: own study

There is, however, no universally accepted method for motivating subordinates.

The quest for finding the right reward and motivation system is as old as that for the ideal leader.

In the 20th century one of the best-known motivational theories was the one developed by

Abraham Harold Maslow (1908-1970). According to his theory, human needs are organized

hierarchically, and motivation can be achieved in different ways depending on the individual’s

actual level of needs

At the lowest level, physiological needs are placed. When an individual struggles

for sheer existence, it is most effective if the leader motivates him/her by the means associated

with it: accommodation, catering. Of course, money (payment), for which all these can be

purchased, can also be a good tool for motivating those on the lowest level of the motivational

pyramid. The second level of the pyramid is security, which is not only protection from war and

terror attacks, but also indicates that work can be carried out under safe conditions and with non-

harmful ingredients and materials. This also includes safety of work. If the employee is constantly

afraid of losing his/her job, the main driver of his behaviour will be the security motive.

OUTPUT TRANSFER VARIABLE INPUT

HUMAN COMPONENT -individual features

-group effects

ORGANISATIONAL COMPONENT

-technology -structure

PERFORMANCE

SATISFACTION

LEADER’S MOTIVATION STRATEGY


41

The human is a social being. In order to identify him/herslef, to achieve his/her goals

he/she needs to search for partners. That is why the third degree of the motivational pyramid is

reserved for relationships, for the sense of belonging – as the last fundamental motive. But

feelings of belonging can be overwhelmed by the need for acceptance and appreciation - when

the worker is not just a member of a community, but his work is recognized and appreciated.

At the higher levels in the motivational hierarchy, the needs of the so-called mature

worker such as cognitive, aesthetic, and transcendental needs, can be found. This also includes

the need for self-realisation in which the individual values freedom, creativity and independence.

Although organisations rarely provide room for self-realisation at lower hierarchical levels,

employees can gain continuous motivation from the fact that self-realisation is present on the

higher hierarchical levels, in leadership positions.

There were many to criticize Maslow's theory. The most objectionable feature is that,

according to Maslow, the different levels of motivation become important only in succession - with

the previous level’s saturation. However, in most people, they are present and generating

motivation at the same time. What's more, when an individual encounters an unsatisfiable need,

he/she can go back to the already saturated level and seek motivation, positive impetus there

(e.g. grief eats). John Hunt (1938 -2015) started out from this theory when developing his theory

of workplace motivation. By developing his theory, he did not only notice that individual goals are

reflecting values, beliefs, experiences, but that they may also dynamically change, depending on

age and circumstances. In addition, goals may differ in strength and importance.

In his theory, the comfort associated with the physiological level is not lesser than

the structure motive describing the nature of work, or any other organisational motives. Relations,

recognition, power, and autonomy as a motive also appear in his system. However, he also

points out that motifs do not define behaviour, only affect it.

Although Maslow’s and Hunt's models are very complex and depict the diversity

of individual motivation, leaders still need tools and models that clearly indicate what incentives

they should use. Herzberg (1923-2000) tried to solve this problem and split the organisational

features into two groups - motivators and hygienic factors. In his interpretation, hygienic factors

are features, the lack of which creates great dissatisfaction, but the abundance of which does not

create motivation at all, at best produces neutral attitudes. Working conditions, relation of the

employees and that with the manager, as well as salary belong to this group. According to his


42

idea, motivational factors are those that increase employee satisfaction (while their absence does

not lead to job dissatisfaction). Such motives may be the potential for development, promotion,

performance recognition, and the form of work itself. If managers motivate their subordinates by

vertical job enrichment rather than horizontal workload, they cannot only increase performance,

but may influence the motivational structure and self-image of the subordinates through the

notion of self-actualisation as well.

McClelland's (1917-1998) motivation theory is based on the possibility of parallel existence of

needs. He distinguished only three basic motifs, combining the typology of the hierarchy of

Maslow and the system of Herzberg's hygienic factors and motivators. In its system, workplace

motivation develops along three dimensions: relationship, performance and power. In order to be

able to determine which of them is the most influential in case of individual employees, staff

members were examined from six aspects:

• Importance of obeying rules

• Extent of responsibility

• Importance of individual performance

• Balance of reward and punishment

• Transparency of the organisation

• Team Spirit

Based on the answers to the above questions, he labelled people relation motivated if to

maintain social relations was important and a high desire for acceptance by others and the

desired to build friendly relationships for mutual understanding and compassion.

Performance-motivated employees, on the other hand, are striving for success. Their goal is

to exceed the performance of others or to achieve the same performance in less time. However,

they reject the situations that are of too high or too low risk.

Leaders are a very special group of organisational staff, hence, in their case it may be

important to define a basic motif, which - according to McClelland - is power, the ability to

influence others, and to strengthen own authority. Of course, leaders may also have other motifs,

as each organisational member can be characterised by a mixture of these three basic motifs.


43

4. ORGANISATIONAL GOALS AND THEIR MEASUREMENT

The activities and performance of organisations can be measured and tested in many

dimensions. Previously, differences in effectiveness and efficiency have been discussed, but in

case of an organisation as an entity, performance can be measured from the point of view of

profitability and equitability.

Figure 13. Indices of organisational performance

Source: own study

4.1 MEASURING ORGANISATIONAL PERFORMANCE

Most organisations have specific performance requirements for their own operation. These

can be indicators for governance, organisational processes, products, services, or about the

market impact of the organisation. According to Robert S. Kaplan and David P. Norton (1996),

things that organisations cannot measure, cannot be managed by them either. However, the

exact definition of performance is the precondition for measuring it. Each organisation must be

Societal needs

Strategic goals

Operative goals

Outcome Impact Output Transformation Input

Effectiveness

Environment

Organisational processes

Efficiency Profitability Fairness


44

able to determine the relevant organisational performance. The SIPOC method can be used to

help managers in this. The method focuses on five key corporate areas.

1. supplier - aspects of supplier selection (what institutional relationships does the

organisation possess, who are the "input" companies)

2. input - the quality criteria of inputs provided by suppliers

3. process - the quality, efficiency and effectiveness of the organisation's main activities and

services

4. output - Indicators of the organisation's products and services, and measurements of the

impact of the organisation on its external environment (customers, partners)

5. customer – aspects defining customer requirements (who are the customers of the

institution's products and services)

After the definition of performance, the next momentum is quantification. Indicators of the

performance shall be determined by the organisation (’s leader) and the optimal / expected level

of theirs must be determined.

Indicators, like metrics already discussed in case of decomposition units, are well defined if

they can measure the performance of a particular activity, process, or department at the highest

level, can take into account the power relation of the process owner or the organisational unit,

and which indicators it can relevantly influence by his/her decisions.

• Input Indicators - What is Available? What and how many resources are arriving into the

organisation or will be used? e.g. number of employees, number of cases received

• Output Indicators - What / How Much Does It Produce? e.g. Number of finished products

• Indicators measuring financial aspects - What is its financial management like? eg:

Expenditures, revenues, subsidies and their timing

• indicators of capacity utilisation - How much did it utilise its resources? e.g. calculating

useful running time for machines

• Efficiency indicators - How are the results related to the resources used? e.g. the size of

output per worker

• Effectiveness Indicators - What is the relationship of indirect effects and direct outputs of

performance of the institution with the strategic goals of the institution? e.g. the new ideas

developed by the R & D department and the proportion of products launched from it


45

• Impact Measuring Indicators - What indicates the achievement of the medium and long-

term goals? e.g. whether new presentation and packaging has increased the brand loyalty

of consumers

• Turnaround Time Indicators – With what turnaround Time Does the Organisation Perform

its Tasks? e.g. the average time for dealing with a case

• Satisfaction Indicators - What do customers think about the quality of the services provided

by the organisation? e.g. score of customer satisfaction

4.2 FAIRNESS

A special part of organisational performance is the satisfaction and commitment of the

members of the organisation. Measuring members' performance and encouraging their activities,

however, is a very complicated task, especially when the management is trying to find a universal

tool. Most reward systems - whatever complex they may be - cannot properly serve their goals.

Employees often feel remuneration inequitable, disproportionate to their performance. The equity

theory calls attention to the fact that employees do not look at the reward in itself, rather they

consider how much input they have invested in a task and what they have received (result -

outcome) and then compare their input -outcome proportion with that of others. The theory also

points out that not the actual results, but the energy needed to achieve them is the basis for

comparison, so the rewards derived solely from the performance cannot lead to optimal results.

In case of discrepancy, most people first alter the input - changing the time and energy of

work. They try to adjust it to the - in their view, unfair - reward. Only in a very small percentage of

cases does unfairness trigger a process that results in the change of the result - in this case, in

the change of the level of reward, - even though this would mitigate the feeling of injustice.

In the short term, it also provides reasonable result (a decline in dissatisfaction) when an

individual re-evaluates his/her own abilities and competencies and adjusts their perceived level to

the level of the results, but in the long term, this has a negative effect not only on the person but

on the organisational performance as well. It curbs the individual's urge to develop, his/her need

for higher motives, and their self-esteem too. Likewise, it will yield suboptimal results if the image

of the reference person is distorted by the employee to see him/herself in a more positive colour

compared to the other person. Indeed, the sense of inequality puts any (small or big) reward, be

it of any nature, in a different colour.


46

In addition, it is important to realize that not only the motivational structure of each person is

different, but motivation is actually a process that requires the individual, in this case the

employee, to realize that he/she has unmet needs.

According to the theory, a person who is perfectly satisfied with his/her situation can only

be motivated to action if he/she we create needs and thereby an internal tension beforehand.

This could happen for example through status products or through higher motifs such as

recognition of demand or self-realisation.

Figure 14. Schematic model of the process of motivation

Source: own study

4.3 GOAL SETTING THEORY

The goal setting theory states that the goals themselves are motivating forces. Well-

measured, clear goals, alike needs, induce behaviour. Determining the right goals will thus help

the organisation to increase employee performance - which can be done along multiple indicators

as described above.

According to the theory, post-behavioural rewarding or punishment does not motivate

employees in the long term because workers are not really aware of exactly what performance

URGE TO SATISFY THE

NEEDS NEEDS

MOTIVATED BEHAVIOUR

Unmet needs Decrease in

internal tension

Internal tension Drive Searching behaviour

Satisfied needs


47

the organisation expects from them and why they have to behave in the given way or perform

certain activities. For this reason, Edwin Locke (1938- ) considers the preliminary determination

of organisational goals and raising awareness of workers in the workplace desirable.

According to the goal setting theory, specific goals lead to better performance than

vaguely formulated guidelines. This is especially true when the goals are challenging for the

individual (because in such cases higher order, e.g. self-realisation motives are activated) since

then their efforts to achieve the objectives are proportionately greater. To increase performance,

it is essential that the employees accept the goals set for them and that they are able to reach

those goal. It has a significant negative effect on the employees when they are unable to reach

their goals; either because they are not in their power to make the necessary decisions or to lack

the skills and competences required for the task.

Acceptance of performance goals will be enhanced if subordinates are involved in the

process of their definition. Participation also ensures that no unreachable goals would be

identified. However, the authorisation is important not only when defining the objectives, but also

in relation to the control process as well. Self-control is a stronger motivating factor than external

control. Whether it is possible to monitor the employee's performance - performance goals, or not

- continuous feedback is of utmost importance for sustained motivation.

4.4 MANAGEMENT BY OBJECTIVES

The process of goal setting and achievement is the core of the Management by

Objectives (MbO) philosophy. The essence of the system is to emphasize the leader's target-

setting role and to accept that subordinates are able and willing to work more efficiently for the

purposes they know and accept. The system is unique by not only involving employees in the

decision-making (goal - setting) process but also striving to define customized, specific goals

and timeframes for each employee. The disclosure of the objectives allows the performance

(goals) to be comparable and may also increase employee engagement with the goals.

The theory is well suited for simpler positions where performance indicators can be easily

and clearly identified. In such cases, it is possible to avoid games that are frequent in more

complex positions. While MbO is also a tool for controlling the subordinates, it concentrates on

the fact that it is much more likely that the goals will be accepted by involving the employees in


48

the goal - setting, and with this increase employees' commitment, performance, and ultimately

satisfaction.

The dynamic design of the system and the constant re-design of goals will allow

individual goals to evolve in line with their competences and future aspirations, reflecting not only

the past performance of the subordinates, but their self-image and self-development needs as

well. Thus, the system is not only a suitable tool for increasing organisational performance, but it

also provides a good input for individual career planning and education development plans.

The system of Management by Objectives is best understood by studying its process,

which can be divided into four phases:

1, goal setting

2, realisation

3, evaluation

4, management training

The first phase of the process is the setting of goals, in which the leader seeks to define

more stimulating, more challenging goals, while the role of the subordinates is to reflect on the

reality (reachability) of those goals. In the goal setting phase targets for the given period are set

at all levels of the organisation. These goals are the breakdowns of higher goals at the lower

levels, up till the workgroup or individual levels. At this stage, it is very important that the leader,

together with the employees, cooperatively defines the goals so that the indicators can become

part of the employee's motivation system and generate satisfaction.

The process of goal - setting is followed by the implementation phase. This phase does

not differ radically from other performance evaluation systems. During the phase, individual

and group work is performed; however, throughout the delivery phase the subordinates

consciously strive to achieve the goals assigned to them, are able to evaluate their own progress

in a reflective way and have a clear picture of not only the aim to be achieved, but also

of its reason and importance.

The third phase is measurement or control. Commonly accepted goals always apply

to a given period of time. Performance is measured at the end of the period. However, the real

advantage of the system is not that it offers an opportunity to identify deviation from the set goals,

but that while the subordinates participate in setting targets, they are (or may be) also interested


49

in exploring the causes for deviation at the end of the performance period. Deviations also

provides opportunities for determining individual growth / development strategies.

The fourth step of the process is leadership development. As through the introduction of

the process it numerously been emphasized, MbO is a participatory technique that presupposes

employee involvement in preparation and decision-making. Accordingly, evaluation does not only

point to organisational and employee shortcomings, but it also provides an opportunity to identify

areas to be developed for leaders. It can reveal the leader's shortcomings inf skills or knowledge,

which can be improved through leadership development programs. Leadership training is also

connected to an appropriate motivational system in the MbO, which ties the reward of the

managers to the performance indicators accepted by the organisation.

The main advantage of MEV is therefore that it encourages both managers

and employees to work for organisational purposes. While it offers better insight and participation

on the lower levels, it will stimulate leaders at higher levels with financial incentives to reach the

goals. The disadvantage of the system lies in the fact that while those on the lower levels seek to

protect themselves and seek lower performance targets during the target setting process,

managers are, as a result of the management reward system, interested in setting higher targets.

In addition to the features presented in connection with the goal-setting theory, the goal-

performance relationship is strongly influenced by the organisational culture, the individual's

commitment and the leadership-subordinate relationship.

5. SITUATIONAL LEADERSHIP

The leader as a person, or leadership as a process can never be interpreted in itself

(leaders need to be followed) and good leadership is never self-sufficient. The point of leadership

is that the leader encourages the employee and the whole organisation to reach

the organisational goals. Consequently, leadership style is ideally influenced by the leader's

personality, the personality of group members, the goals, needs of group members, group

situations, and organisational goals. There is, however, another factor that is closely related to

the functioning of organisations as open systems, namely the broader social, economic and

cultural environment that has a significant effect on management systems.


50

Therefore, organisational theoretical trends are worth approaching from a situative

approach, and all trends shall be interpreted within their own social and economic context. For

this reason, numerous leadership theories will be presented in this chapter. In relation with each

of these trends, the relevant social and economic context will emerge so that the inner logic of

trends can be better understood.

5.1 CLASSICAL SCHOOL

Management and organisation as a science was born at the beginning of the 20th century.

Initial management systems sought organisation leadership and their ideal target status

regardless of environmental conditions. By the second half of the century, however,

the approaches that viewed organisations as open systems gained ground increasingly.

Management to be considered a separate discipline the management and organizing principles

of Taylor, Ford, Fayol and Weber were necessary. Among the causes of their development,

in addition to industrialisation, the expansion of markets (owing to the construction of roads, and

railway networks), and the growing of unskilled labour stemming from urbanisation was the most

relevant. The change in economic and social conditions necessitated the creation of thumb rules

that enabled the mobilisation of a huge number of employees for a given organisational purpose.

5.2 CLASSIC ERA IN AMERICA

Historical and economical background:

• colonialisation of America,

• large-scale exploration and exploitation of natural resources,

• rapid growth,

• expansion of markets.

Labour market situation:

• more than half (58%) of workers are immigrant,

• lack of linguistic competencies,

• unskilled labour,

• lack of industrial training,


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• long working hours (60+ per week),

• low wages,

• very strong fluctuation (worker are exchanged 4-8x annually).

At this time, capitalist entrepreneurs and managers were also uneducated. Engineers'

qualifications and experience were also limited, confined to technical - mainly constructor-

designer - knowledge. Leaders in general knew little about technology, productivity, wage

systems, and the effect of fatigue. The management of production was still patriarchal,

craftsmanship like (daily wage, direct management) in large plants as well. There was no long-

term HR. (Employees were dismissed if they were not needed on the next working day

or workers fled from inhumane working conditions.) As a result, productivity in the industry was

very low.

Frederick Winslow Taylor (1856-1915) wanted to offer an engineered approach to this

problem. The Taylorian system is based on a highly demarcated human image.

According to Taylor, mankind is lazy by nature and just thinks of entertainment. They can

only achieve happiness by consuming goods. Therefore, people can only be motivated for work

with financial means. Since hypotheses 1 and 2 contradict each other, for the sake of prosperity,

man must overcome his own nature with discipline. However, since man, at least blue-collar

workers, would (could) not do it on their own, they must therefore be subject to strict rules.

Accordingly, separation of physical and mental (blue and white collar) work was necessary.

Taylor did not entrust the worker with the task of searching for and developing the technology for

delivering a given task; it had to be planned and prescribed in advance with the use of scientific

knowledge.

Engineers, who possessed the science of increasing productivity (and who were

not subject to the principles set out above) were the best to create these rules, thereby giving

workers access to income, consumer goods and happiness.

According to Taylor, long working hours and low wages were the main obstacles to

industrial development. His purpose was to develop a system with high wages and low costs.

According to his theory, increase in productivity makes conflict between the employer and the


52

employee "unnecessary", as they both profit from it at the same time. Employees receive higher

wage and bonuses in case of extra performance, the employer realizes a higher profit.

In line with his theory workers must work at a high rate for high wages, but they can only be

demanded performance that they can sustain on the long run without endangering their health.

However, not everyone is capable of this continuous high performance. It is therefore necessary

to select the (physical) workers. In Taylor's system, the task of management was to study

the character, nature and performance of workers, and then find the corresponding work / task for

them. To help determine the appropriate workload different methods and procedures have been

developed:

• time analysis (the workflow is divided into work elements/tasks, the time spent when

delivering the task in multiple ways is measured with a stopwatch and the new workflow is

combined from the shortest elements)

• uniform operation (tools, devices, various technology specifications, and elements of the

operation and their operation time shall be standardized)

• task management (the workers receive individual predefined tasks and their wages are

differentiated depending on their performance)

• functional management (job preparation and administration - theoretical work - is done at

the job office, the task of team leader/ foreman is to train, manage and control the work)

Taylor and his colleagues standardized the work of the worker by time analysis and motion

analysis, reducing its complexity. With this system, he denied the workers the opportunity of

developing and implementing the self-developed technology of the task prescribed for them.

Another disadvantage of the Taylorian-system is that it increased the number of unproductive

employees (the number of "economists" working in the bureau).

5.3 MECHANISATION AND INDUSTRIAL PRODUCTION

Technological progress and the increasing industrialisation required the further

development of the Taylorian system. Conveyor belt based production and the associated

management and organisational principles were formulated by Henry Ford (1863-1847).

He assigned the tasks and machines to the production process along its length.

The products to be processed were delivered by the workers on a conveyor belt, so that the work


53

intensity was determined by the speed of the belt. For this, a broad standardisation of products

was necessary. The best example of this is the Ford T model, in case of which Ford itself stated

that he would satisfy all the demand on the market if the demand was for a black T-model type

car.

The introduced technical innovation, the conveyor belt, facilitated not only the production,

but also the organisation and its management. Coordination of the activities along the process

were "programmed" into the design of the production line. It united the time norms, made the lead

times and the unit time clear, and production easy to plan. Constant compliance with the rules

minimized workers' efforts. Rationalisation of the work organisation reduced the need for middle

management, the size of the huge unproductive group of personnel Taylor was criticized for,

and the chance of error.

5.4 CLASSICAL ERA IN EUROPE

The situative approach requires that American leadership theories be strictly isolated from

European schools. In Europe, there were completely different circumstances in which initial

management schools were established.

Economic and historical background:

• people of working age, mainly the unskilled workers and agricultural workers, are

emigrating,

• natural resources are explored, the volume of stocks is adequate,

• rapid growth, due to the industrial revolution and mechanisation,

• transformation of markets, struggle for traditional trade routes, colonialism and the

redistribution of the known world.

• Labour market situation:

• unmet demand on the labour market (despite the fact that urbanisation still accounted for

large numbers of immigration from agricultural areas)

• long working hours (50-60 hours a week)

• low wages,

• limited fluctuation - companies could not afford to lose a worker,


54

• In addition to the unskilled - agricultural labour force, multiple generation of skilled workers

are emerging,

• local labour market - workers speak well on their native language.

At this time, production management was carried out even in big plants with patriarchal and

small craft industrial methodologies, but further development of manufacturing production began.

Workers were already paid weekly for the sake of not letting them leave, and fringe benefits

appeared alongside the traditional wages. Jobs, tasks could be inherited, which relocated the

burden of training from the organisation to the employee.

5.5 FRANCE

Due to its position on the Mediterranean sea, France was particularly in danger

of emigration. For this reason, local companies have quickly realized that manpower is not like

a tool or a simple machine. Other systems and processes are needed if they want to regard

workers holistic, and not the same as in the American mechanistic structures.

Henri Fayol's (1841-1925) system focuses on the person responsible for carrying out a task.

The organisation is shaped by the functionalist division of labour. Its corporate activities are as

follows:

• technical (production, machining, processing);

• commercial (procurement, sales, swap actions);

• financial (capital acquisition and capital consolidation);

• security (property and personal protection);

• accounting (inventory management, balance sheet preparation, cost accounting, statistics);

• management (planning, organizing, leading, coordination, control).

In this sense, management is the task of each organisational member. Managerial

activities are no longer a a privilege, nor a one-sided obligation of the organisation's leaders.

Of course, the higher a person is in the organisational hierarchy, the more important his

managerial role is. Management at Fayol, however, is not the same as the traditional

management in other systems. The exercise of managerial tasks, like other functions, is shared

between the top and bottom levels of the organisation's social organisation.


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The essence of management is creating an optimal synthesis between the functional

areas of the organisation by defining the organisation's overall action plan, coordinating

and synchronizing its efforts.

management consists of basic tasks:

• Design, is nothing more than researching the future and defining a detailed program for

action (multi-year plans). The principle of design is that individual interest must be

subordinated to the public interest, that is, the interests of the organisation must always be

placed over the interests of the individual. The aim of the design is to create stability,

whether it is displayed in the long-term economic benefits or the persistence of staff.

• Organizing means the establishment of the organisation's dual material and social

organisation. According to Fayol, personal contact is important. In his opinion, the strength

of the organisation lies in the unity of its members. In contrast to Taylor, he regards

moderate specialisation as ideal and a flat (few hierarchical levels) organisation. Each

organisational unit must be empowered, and the power shall be share between the various

departments and actors of the organisation in proportion to their responsibility. He regards

self-organisation and taking responsibility very highly.

• The aim of leading (direct control) is to instruct the execution of tasks with. The basis

of direct control is authority, and its purest form is paternalistic leadership. In order for the

chain of command to function properly, it is necessary to specify the hierarchy of the

system, to clarify the distribution of power and responsibilities.

• The paternalistic leader has the right of disposition and instruction, but he must also

assume responsibility for his decisions. The leader can force employees’ obedience

if obedience triggers hard work, steady, mindful and diligent work. Since the leader is also

responsible for maintaining discipline.

• Coordination is the task of unifying and synchronising work and the efforts to implement

them. In Fayol's system, the unity of the provision is of the utmost importance, that is, every

employee can receive instructions from only one person.

• Control means monitoring the compliance with issued rules and instructions.

The assessment is based on the principle of fairness, according to which the reward /

punishment must be in balance with the quality of the work performed. Anyone who has

worked for the organisation can be reprimanded with a fair pay, but unsuitable employees


56

must be released. An important condition is that the one monitoring shall be competent and

impartial and that control is enforced at all levels of the organisation.

There are leaders situated on higher hierarchical levels in the Fayolian system as well that

also relate to all organisational activities, but the most obvious is of course management. These

positions - to distinguish it from the leadership task – is called are called governing positions.

In this definition, the role of governance is to direct the organisation to its goal, by making

the most of the resources available, and by exercising the six organisational functions together.

5.6 GERMANY

While France in the twentieth century, was struggling with the problems caused by

emigration, Germany – mostly owing to its central position - did not aim at retaining workers but

at increasing their efficiency. The philosophy of Taylorist structuralism was fundamentally well

matched with the national culture, and the military production very quickly adopted the Taylorian

principles. In the heavily civilized society, however, there have already been enormous

institutions, which could not be organized and controlled on the basis of Taylorist principles. The

same weakness occurred in the administrative departments of production companies.

For filling the gap, the theory developed by Max Weber (1864-1920) based on the

analysis of power systems was the most suitable. In developing his organisational concept,

Weber started from the idea that all human communities needed rules for social (inter)action.

In organisations, rules also form the basis of work performance, work organisation, and create

the starting point for leadership. In his interpretation, leadership (domination) is the probability

of obedience. According to Weber, for organisations the ideal of power is that of rational sources.

Since the starting point for rational domination is the belief in the rule of law and in the

orderly order of people commanded by the rule of law, Weber concluded that bureaucracy is the

most relevant organisational system for rational domination. Its reliability exceeds other

organisations’; it provides a suitable framework for rational creative work and the development of

efficient organisational activities as it is based on constant, foreseeable, predictable, comparable,

reasonable and professional formal procedures.

The ideal bureaucratic organisation is based on a functional division of labour.

Its hierarchy is clear and easy to understand, just like the rules underlying its operation. Although


57

the system is - because of these - highly impersonal, Weber believes that impersonality is more

positive than a negative, since rules and procedures are common to all, control, promotion and

reward therefore exclude all subjectivity. Bureaucrats are selected and promoted based on their

knowledge, and professionality. In addition, impartiality a pro to the outer world as well, as

compliance with the rules uniforms the behaviour and decisions of the organisation - and its

employees – regarding external partners. Accordingly, the solution of a particular situation is

always the same for every clerk and client - the administration is impartial.

The bureaucratic work style results in a well-functioning organisation for a long time under

stable market conditions, and for large / well-staffed organisations, the thumb rules

recommended by the bureaucracy theory are also indispensable. That is why for public

organisations bureaucracy is still the most common form of organisation since it enables the

organisation to operate as a comprehensive and well-regulated system to suit a slowly changing

environment.

5.7 CONTINGENCIALIST APPROACH

By the middle of the XX. century it became clear for business leaders that they should not

only focus on internal affairs. They cannot find an ideal management system for their

organisation if they do not consider their organisational environment. However, in order to create

management systems that take into account the organisational environment, they need

to redefine the concept of the organisation. Former organisational theories considered companies

a black box with inputs (materials, money, human resources) a transformation process

(technology) and outputs (goods and services). However, this organisational image had to be

supplemented. Both managers and management researchers had to come up with the idea that

in ideal case there is a feedback between the organisational outputs and inputs that allows

feedback from the organisation's environment to be incorporated into organisational processes

and facilitates the necessary intervention. This external dependence is the reason for the fact that

no ideal way (no one best way) of organizing could be identified, that the most appropriate

solution for the organisation is contingent upon environmental and internal characteristics.

The pace of environmental change, therefore, determines not only the organisational structure

but also the management system.


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However, it is important to keep in mind that, for the time of the emergence of the

contingency theory, the members of the organisation are no longer equal to the actors of

Taylorian or Weberian systems. Due to scientific and technological developments, employees

already have a high level of professional skills, leadership knowledge, conflict-tolerance

and resolution ability, communication and cooperation willingness and capabilities. They adapt to

the organisational environment flexibly and fulfil various roles that are acceptable to them based

on their motivation and interest structure. Employees, therefore, have in mass become valuable

for the flexibility that the changes in the organisational environment have made necessary.

In the contingencialist organisational approach companies are open systems. They are

in continuous interaction with their environment. In this respect, we can consider an element of

the environment any condition, effect, and factor influencing, limiting and defining the behaviour

and activity of the organisation and its constituent individuals or groups.

In the contingencialist organisation, the leadership style must fit the conditions of the

management system, so the contingency models aim to identify the situational factors that

managers need to be aware of when creating their leadership style. Contingency leadership

models have two approaches. The schools - while agreeing that the leader, the management

needs to examine and fit to the organisational environment – there is no consensus regarding the

learnability and teachability of leadership.

There are some models that, based on personality - centred theories, examine

the attitudes of the leader to determine the solutions (organisational and management structure)

that fit with his style. Fiedler's (1922-2017) system, which is based on the Least Preferred Co-

worker questionnaire focuses on the leader-subordinate relationship from the situational factors.

The structure of the task and the potential power (position) of the leader are the examined

dimensions. Based on these, he tries to define the most appropriate organisational environment

for the leader's personality, orientation (task or relationship orientation).

According to the other school, leadership is a competence that can be learned, so after

examining and measuring environmental factors, a management style that fits in with the given

condition is defined. For instance, in the case of Vroom and Yetton's decision tree, the leader

must choose the befitting way of decision making after analysing the situation. When analysing

the organisational situation, he has to look at the nature of the problem that needs to be solved


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and the context in which it emerges, which are important features when choosing a leadership

style:

• what is the importance attributed to the quality of the decision (rationality)

• Does the leader have useful information and expertise?

• Does he know exactly what information he needs and where he can get them?

• Is it decisive for the implementation of the decision whether or not the subordinates accept

it?

• what is the likelihood that subordinates will accept the unilateral decision of the superiors?

• Is the motivation of the subordinates strong enough to achieve the objectives that the

problem that arose requires them to?

• Are the subordinates inclined to break into different parties solving a problem (conflict)?

• Due to the nature of the questions, the leadership style indicated by the situational

characteristics resemble the set of decision-oriented leadership approaches:

• Autocratic 1: The leader makes the decision alone

• Autocratic 2: the leader asks for information, but makes his decision alone

• Consultative 1: The leader shares his information regarding the situation with a selected

group of subordinates and asks for their information and advice. He decides alone, but

informs the employees about the outcome of the decision

• Consultative 2: The leader discusses the situation with the subordinates as a group. He

makes his decision based on voluntarily shared information

• Group: Leaders and subordinates consult, and the group makes the decision based on

voluntarily shared information.

Hersey and Blanchard's system is also based on the learnability of leadership skills and on

the leader's adaptation constraints. Its bottom line is that there is no best leadership style.

Management is effective if it meets all aspects of the organisational situation. It is up to the leader

to adapt flexibly to different situations and, if necessary, to change his leadership style. The

model measures the organisational situation through the maturity (expertise, intelligence, self-

reliance, willingness to take responsibility) of employees and formulates proposals for the extent

of task and relationship orientation.


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Figure 15. Leadership behaviour in relation to employee maturity

Source: own study

A directing leader is required if the maturity of the subordinates is low (e.g. for the

Taylorian, Fordian systems). The leader’s role in such organisational situations is decisive.

It is his job to prescribe tasks and to ensure the conditions for their delivery. He/she instructs and

regularly checks the staff.

If organisational members already have some expertise and increasing their maturity is

an organisational goal, an encouraging (coaching) leader is needed. In such a case, the leader’s

aim is to increase the self-confidence of the subordinates so that they would be able to work

independently on a long-term basis. To this end, the leader conducts bi-directional

communication, recognizes and rewards the subordinates’ results, engages them in decision-

making, and in some cases lets them make a decision.

Sup

port

ive

be

havio

ur

Directive behaviour

supporting coaching

directing delegating

high low

MATURITY OF EMPLOYEES

low

high

M4 M3 M2 M1


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Supportive style leadership is ideal if the organisation is to retain the adequately mature

workers (e.g. Fayolian system). To this end, the goal is to increase employee engagement

through the opportunities and features offered by the job. The task itself is not so much a goal as

a tool (for more details see the technique of Management by Objectives in Chapter 4.4).

If the maturity of the organisational members is high, the delegating leadership style is

sufficient, in which case the manager entrusts the right employees with the task and then let them

solve the problem independently (e.g. Weberian system). In such situations, the relationship

between the leader and the subordinate is factual and task-oriented, the motivation of the

subordinates is not the task of the leader he/she is only responsible for the creation and provision

of the necessary circumstances for work.


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6. GROUPS IN THE ORGANISATION

Staff performance is closely related to workplace satisfaction. It is a proven fact that the

performance of organisational members can be boosted by allowing them to meet their specific

social psychological needs. Although the role of leaders in organisational life is paramount,

the impact of peers has a significant influence as well. Individuals can be motivated not only by

economic incentives but also by various social and psychological factors. Behaviour is also

influenced by factors like, feelings, emotions and attitudes.

The informal working group is also an important organisational factor. The group has

a major role in determining the attitude and performance of individual workers. Accordingly,

the organisation as a social system influences the formation of organisational roles and develops

its own norms that are different from those provided by the formal organisation.

The group is a formation of two or more interdependent individuals who interact, act

collectively or cooperate for a common purpose. For this reason, the organisation can not only be

considered a group in itself, but it also includes a system of countless formal and informal groups,

depending on the size of the organisation.

For formal groups, it is easy to determine the ideal structure of the groups on the basis of

its size, composition, roles within the group, status, rules, norms and the composition of the

group. However, for informal groups, group membership is more likely to be decided by members

of the group, so the organisation has no direct impact on size or group composition. It is therefore

important to consciously address and manage the groups that emerge and has been deliberately

created and the factors that influence the behaviour of their members.

The behaviour of group members generally depends on the structure of the group, but the

personal resources of the group members, the nature of the task assigned to the group,

the performance of the group, the group members' satisfaction and the external conditions of the

group also have significant effect. Under the external conditions, the organisational structure as

an external feature of the group, the division of power and responsibilities within the organisation,

the organisational strategy and rules as well as the human resource management system

(recruitment, selection, performance measurement and evaluation, remuneration, training) shall


63

be considered. The resources allocated to the group, the physical working conditions and the

organisational culture shall also be taken into account when analysing external factors.

6.1 GROUP DYNAMICS

For groups – especially for informal groups characterized by emergent development -

to be able to perform well, they must undergo three important phases. The first phase of the

group dynamics is forming. For formal groups this is the result of organisational decision and the

composition of the group is a given for group members but belonging to a particular group of

people in informal groups is often not such a clear situation. However, the first phase must end

before the group can enter the next phase. The second phase is the stage of debate (storming)

when members' value system, beliefs and attitudes collide with each other. When everyone can

tell their opinion - and ideally lives with this right. A prerequisite for well-functioning groups is to

expose the intra-group conflicts within this group development phase, so that it will not to be

source of conflicts at later stages.

One of the most important moments of group development is the phase of norming, which

is often neglected and forgotten through lack of time or awareness. This is the stage where group

members lay down the rules that govern the cooperation. They create the values, norms, and

thumb rules commonly accepted by the group members agree on the roles, responsibilities within

the group, and create the culture of the group. The established norms can apply to external

appearance, public behaviour, communication mode, as well as evaluation of performance,

attitude towards deadlines or the allocation of resources. If these rules are not recorded, are not

explicitly formulated for group members, the group may get stuck at the stage of storming and be

unable to achieve optimal performance.

The fourth phase is the phase of performance. Groups can concentrate on reaching their

goal if they have passed the three phases already presented. However, the unobstructed flow of

group dynamics is a necessary but not sufficient condition for optimal operation. It is also

important to understand the purpose, and motivations of the members and whit kind of fears they

might have regarding their group membership.


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6.2 MOTIVATION

For a human being the need for belonging is a fundamental motive, since man is a social

being. Group membership, social support, means strength and resources to achieve individual

and group goals. Inclusion by the group can increase the individual's self-esteem, as well as the

place and rank in the group and the status. The group, however, is primarily concerned with

transmitting the feeling of reception, security and acceptance. It strengthens the values

of individuals, stabilizes their belief system, and forms an indefinite framework.

However, group membership does not only have advantages. Before joining a group,

individuals should in any case consider the cost of the group membership and the risks

associated with it. It is expensive to belong to a group. It takes not just time and energy, but often

resources to sustain group membership. The other members of the group may, however, refuse

to accept personal investment. There may be internal tensions and contradictions (especially

when the phase of the standardisation is not properly closed), which leads to the rejection of the

individual. After considering all these, the individual should declare his/her group membership

preferences, that is, decide, whether or not to belonging to the group.

Although the groups also have dangers not only benefits even at the individual level,

organisations tend to form (formal) groups most of the time. The consequence of group existence

is the synergy effect, more knowledge and information, multilateral problem solving, a better

understanding of decision and acceptance of participation. Of course, the creation of groups also

poses a threat to the organisation. The first, and perhaps most common, is the insecure

responsibility resulting from group work or decision-making. If there is no specific person

in charge of a particular decision or task to whom one can apply, the measurement and

evaluation of performance is cumbersome. Therefore, in groups with inadequate group norms,

the phenomenon of social slacking - where members consider the performance of the weakest

member to be a standard and are unwilling to perform more than him - is frequent. This may also

be a typical behaviour when the balance of power within the group is shifted and a dominant

leader or intra-group click makes the decisions, taking away the right of participation from others.

Group pressures, however, can not only appear in relation to performance standards, but in

regard to any other object of membership, behaviour, or even purpose, for group members often

strive for conformation, contrary to the organisational purpose of diversity.


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6.3 GROUP ROLES

In a well-functioning group, group members do not do the same work, but share the work

along their comparative advantages. By the end of the standardisation phase roles within the

group also emerge. Three categories of group roles are known in the literature.

Figure 16. Group roles

Source: own study

In a slightly different way from the list on the pie chart, Meredith Belbin (1926-) clustered

the group roles, addressed them with fantasy labels and created the basic roles needed for

the composition of the ideal group. Her theory, regardless of the size of a group, indicates what

tasks (role duties) are needed to make a group work well. One of the most interesting parts of her

theory is that she did not only recognize a single leadership role but divided

the leadership/leadership tasks between multiple roles (at the same time allowing a group

member to fulfil multiple leadership roles). The first such role is that of the COORDINATOR.

Goal setting Taking initiative

Collection of information Providing

information Coordination Evaluation

Encouragement Conciliation Stimulation

Norming Tracking

Contemplation

Blocking Striving for recognition

Dominance Withdrawal


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The COORDINATOR is in fact a manager who aims to coordinate the work of the group

members and to make the most out of the competences of the members. In addition,

the RESOURCE INVESTIGATOR can also be considered as a management role, whose task is

to explore and secure the resources needed to operate the group. He is the connection between

the group and the outside world, he represents the interests of the group outward.

The MOTIVATOR is a typical leader. He has a strong impact on other members of the group,

controls and moves team members.

Belbin's system also draws attention to the fact that in a balanced group, not only leaders

but followers are needed as well. The PLANT is responsible for the continuous renewal of new

and innovative solutions. He is a creative member of the group. The task of the MONITOR-

EVALUATOR is to restrain the ideas that are too overwhelming from the idea-making reality.

Its main task is to evaluate new designs and solutions. He's the devil's advocate. In groups,

where people of such different role are together, are always in need of someone who, despite the

opposing positions, keeps the group together, ensures a harmonious operation. This person is a

TEAMWORKER. His task is to support intra-group communication and to ensure the satisfaction

of members.

The importance of group members in the implementation phase is also undeniable.

The IMPLEMENTER is a practical member within the group. Thanks to his high endurance

and stamina, self-discipline and good judgment, he works precisely and reliably. The role of the

COMPEMENTER in the las phase of the work is cardinal. His rigorous inspection and attention

make it possible to check the work of the group and to avoid mistakes. He is responsible for the

finishing steps, so that the team's work is really high quality.

Whether we talk about the ideal group in the Belbin sense or the common sense, we need to

distinguish between functional and dysfunctional teams. In dysfunctional groups (with suboptimal

performance), members are primarily in contact for the sake of information exchange and

decision-making to help each other perform their duties better. There is no need for collective

work. Their performance is the sum of the performance of the group members. Conversely,

functional (optimally working) groups and teams create a positive synergy as a result

of coordinated work. Their performance is greater than the sum of the performance of individuals.

For this, however, the active participation and commitment of all members is not sufficient, but it

is also important that the members complement each other while working together to achieve

common goals and only to achieve their individual goals. Team members must strive for finding a


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middle ground, constructive conflict management, and consensual decision-making in case of

individual differences. All this in an open atmosphere that allows criticism to be phrased.

•

7. COMMUNICATING IN THE ORGANISATION

Organisational operation is based on communication between organisational entities -

organisational levels, groups, individuals. Communication is also of paramount importance to the

leader, as he or she can practice the management functions (organizing, managing, controlling),

thereby enabling him to effect and motivate the subordinates. It is therefore cardinal that

functional forms and channels of communication are built up in the organisation. For these

channels to be built on the one hand, the leaders of the organisation are responsible – such

channels are called formal channels – on the other hand informal communication channels are

born as a result of the individual motivation of organisational members.

7.1 THE DIRECTION OF COMMUNICATION

Communication, in line with its nature - can be vertical - between organisational levels -

and horizontal - between different organisational units. While horizontal communication plays a

role in synchronising the individual activities of the organisation and in coordinating dependent

tasks, vertical communication supports the organisation's formal power structure.

There are three forms of vertical communication:

1, top-down (downward),

2, bottom-up (upward),

3, two-way.

Downward communication is a classic leadership tool. The leader - in accordance with

his / her habits and leadership style - instructs, informs, or asks his/her subordinates for a task to

be performed. Regarding the contents of the communication, instructions, explanations,

feedbacks, educational messages, as well as policies and instructions belong here.


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Upward communication occurs when the leader is able and willing to receive information

from the subordinates, and if the lower hierarchical levels have such a communication motivation.

The upward communication is characterized by the fact that the higher the level addressed by the

message the more aggregated the information is; the degree of processing and concentration is

growing with organisational levels. Their content includes reports, suggestions for development,

and reporting problems and complains.

In the case of two-way communication, a downward and upward communication is

present at the very same time. Although the other two forms are commonly referred to as

communication, the basic definition of communication can only be related to such interaction.

For the recipient's understanding and intention can only be made clear to the sending party when

it comes to the feedback. Intention is particularly important for communication, since not only the

sending or receiving of information can be deliberate, but the process of encoding and decoding

is also influenced by the intention of those concerned.

Figure 17. Schematic model of communication

Source: own study

Emotion, information

Receiving

Sending Coding

PURPOSE OF THE SENDER PURPOSE OF THE RECIEVER

Receiving

Feed-back Under-standing

Decoding message

CHANNEL

message


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7.2 EFFECTIVE COMMUNICATION

The purpose of the communication is to transfer a message from the sender

to the receiver. The message, however, can be very varied. We are talking about information

when the sender wants to communicate something exact to the receiver. Communication is in

this case is dominantly transferred by the meaning of the sentences. If the sender party intends

to communicate his/her feelings, moods and emotions, the expressive function of communication

comes to the forefront. These messages often contain exclamation and desire phrases. When

the sender wants to influence, he invites the host to act, and uses the calling role of

communication. In this case, the calling sentences have a primary role in communication.

The purpose of communication can be to build and maintain relationships. If communication is to

maintain and improve the relationship with the other person, communication linking function

prevails. It is common to use questionnaires to indicate that the communication is not our

intention, but the receiving of the other party's message. (Language is not merely a matter of

information, but it also has an aesthetic role. The use of the language for this purpose

(e.g. saying poetry, writing novels) is related to the aesthetic function of communication.)

Effective communication, besides the sender's intention, has many other prerequisites.

For example, the use of common language (or signal system) is not exhausted in the language

of communication, because the language has layers. Lack of linguistic stylistic elements and lack

of knowledge of the jargon can be a factor that negatively affects the effectiveness of

communication than if the parties try to communicate with them in a language that is not well-

known to them.

Language is, however, a sufficient condition for effective communication. Communication

parties must have a common axiom system, reference points, and preconceptions to be sure of

the message of the other party. (If we know how the content of the communication is encoded by

the sending party in the reference system, it is easier to decrypt the message and communicate

more smoothly.) The common reality, that is, the consensus of the world known by the parties

involved in communication, is also an important prerequisite for proper communication.

Information, knowledge transfer, what the recipient knows about something is related to it. If this

is missing, the process of communication is much longer, since instead of communicating

information, it is first necessary to establish a common reality by presenting the situation

and outlining its internal logic. Like the common reality, the context has a significant role


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in communication. A message - irrespective of the sender's intention - may be completely

different after the communication situation and the change of communication conditions.

A common interpretation framework and language that enables effective communication

requires the interpreting function of communication - communication when talking about

communication itself through communication. Communication is not just a channel - the sender

can send conflicting messages at the same time to the same situation. In this case, the purpose

of the communication is to clarify the sender's intention.

7.3 THE FORMS OF COMMUNICATION

The parties involved in communication often seek to interact with each other, or they are

separated in time, so there are different forms of communication depending on the sender's goal

and life situation. Besides written and oral communication, we can talk about nonverbal

communication as well.

In the case of written and oral communication, we use the language signal system.

In the case of written communication, the channel, the mediating medium is classically

the paper (previously replaced by stone blocks, clay tablets, textiles, animal skins, and papyrus,

and in the modern age, electronic communication is not necessarily materialized). In verbal

communication, the media through air and technology has enabled people to communicate with

people who are not in a room (phone calls via the Internet).

The advantage of the written communication is a tangible, verifiable note, which is usually

better formulated, more logical, lighter than verbal communication, as the sender has the time to

put his thoughts, feelings into words, words into sentences. Another positive thing is that the

message can be stored indefinitely and physically available later. The disadvantage is that writing

is more time consuming and more difficult than verbal communication; and that, in terms of

direction, written communication is mostly unidirectional in time, it lacks the feedback of the

receiving party and therefore there is no guarantee that the recipient will properly decode the

message. (In the case of modern info communication forms, the act of sending and receiving was

much closer in time, so the classic disadvantages of written communication could be easily

eliminated).


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Oral communication, on the other hand, offers quick and immediate feedback.

As a disadvantage, you may mention the sometimes very noisy communication medium

(channel) that can modify the content of the message or make it difficult to understand it. In

verbal communication, the message is often distorted when it comes to more than one sender to

the final recipient, or its original form is not or is difficult to decrypt. However, a decided

advantage over written communication that, in addition to the use of linguistic signs in the report

may be nuanced, also enrich the nonverbal signals.

7.4 NONVERBAL COMMUNICATION

Writing is man's own, but verbal (by voices) and nonverbal communication is also

possible by the animals. Nonverbal communication is the most ancient form of communication.

We do not even prove that some of the nonverbal signs inherited, born with us. These include

facial expressions expressing basic feelings. Another highlighted group of signs is acquired

through socialisation. Instinctive signs are characteristic of a culture, community, its values and

symbols. A third group of non-verbal signals to consciously learned conventions are included,

which aim to create one by a user defined and implemented. They are often linked

to professional and subcultures. The non-verbal signals transmit information to the outside world

of emotions that play a role in the regulation of social relations. Its role is most pronounced in the

transmission of difficult verbalizable emotional content.

There are many forms of nonverbal signals. We distinguish vocal, motion, position,

and emblematic signals. Vocal sound signals have a huge role in enriching oral communication.

The tone, the sound characteristics of the site includes a focus on language, intonation, speech

rate, rhythm, and voice break even with the volume. The vocal signals that specializes although

non-verbal signals, it is not necessary for its transmission to the sender and the recipient must be

a sky background. Vocal signals are also filled in by phone.

The main groups of Chinese signs are facial movement, gestures and posture (physical

activity). Within the face, we should pay attention to three distinct areas, and we are trying to

reach the signal system of nonverbal communication. One is the forehead and the eyebrows, the

other the eye (look), the third the mouth, and surroundings. It is interesting to note that although

a number of vocabulary deals with the nose as a means of nonverbal communication, the

importance of communication is negligible. Moving faces - touch any of the areas listed below -


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calls the literature mimic. Mimics are usually the spontaneous implications of oral communication.

The most difficult to become conscious / modifiable nonverbal signal system.

The gesture is the most elabourate signal system of Chinese communication.

This includes the movement of the hand, arm of the head and the foot. While the movement of

the head (nodding, shaking) is clear signals, the movement of the rest of the body usually tends

to lighten or amplify the message of verbal communication. Members usually follow the pace of

speech. (A special circle of hand gestures is the elements of sign language that can be used as a

learned language to facilitate communication with the spoken language.)

The nonverbal communication toolkit includes the message space and the signal system

of the different postures. Posture, as well as the intentions, actual state of mind and emotions of

the communicating parties are the same as the distances between the parties concerned. Edvard

Hall (1914-2009) also developed a separate scale for interpreting the message of spatial

distances. He has a confidential distance of 0-45 cm, and his personal distance is within 45-120

cm intervals. In terms of distance, the speaker's intention is not to communicate between two

actors, but to provide information between the sender and a larger organisation such as the host.

The last group of nonverbal signs is the emblems. These include signs related to our

outfits, clothing, and hair doing. Communication is a particularly varied way of accessories,

including jewellery, the language of which has historically been much more pronounced than it is

today. The same can be said about the fields of gifts, including flowers.

7.5 EMOTIONAL COMMUNICATION

Emotions influence organisational behaviour in many ways. This effect has direct modes

such as emotions that trigger different behaviours and are indirect, which influence behaviour

through mediating mechanisms such as motivation or perception. Integrative emotions

are intended to strengthen interpersonal relationships, such as love, loyalty, pride. In contrast,

distinctive emotions lead to differentiation within the group and the breakup of groups, such as

fear, anger, contempt. The third group of emotions is hidden emotions. Although these emotions

may originally belong to any of the first two types, their main feature is that they are distorted due

to self-control, suppression and camouflage. Very often this group of emotions is created by the


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body emotional manifestation, and communication requirements, but it can also lead to social

norms in the background of its development.

Expression of emotions is an important area of communication for three things. A clear

expression of emotions helps the host to understand the status of the sender (emotionally), what

he wants and what the other behaviour has on him. So, we need to be able to express our

feelings and moods. Most of these people are not able to put words in an adequate way, and

presuppose very high language skills when someone uses their poetic imagery to express their

feelings. One of the simplest ways of communicating emotional states is nonverbal

communication, which can not only mediate the basic emotions in a proper way, but with its

broad set of tools it can also give you complex and tense emotions, even without the help

of words.

The emotional intelligence is closely linked to how we are able to formulate our desires,

expectations, and words. Social building is a very important building block to know each other

what the other party desires and how to achieve satisfaction or motivation. However, since

communication of desires is even more complicated than emotional states, leaders are in a very

difficult situation when they want to increase employees' commitment or satisfaction because

they do not have information about desires.

The area of emotional communication includes the reactive feeling - thanks to the

negative feelings - of emotions. This differs from the previous one in that it offers the host party

feedback on its behaviour, its impact, and the situation. However, it does not do this

on a cognitive level, but indicates the impression that psychological and emotional events have

left behind. This form of emotional communication can be of paramount importance for leaders,

since emotional feedback is a good starting point for choosing an adequate leadership style,

creating workgroups, rewarding and incentive systems.

Emotional communication occupies an important place in understanding workplace

processes. Especially because emotional manifestations not only reflect the emotions, desires

and moods of the organisational members, but also influential ones. Observing the feelings of

others (to a certain extent) induces the emotional state in the contemplator, because the

emotional manifestations of others are automatically reflected, and are not deliberately imitated

with less intensity. This replicated emotional expression can also influence the sender and the

entire communication situation through the feedback process. For this reason, many


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organisations have explicit or implicit rules of permissible and unacceptable emotional

manifestations. Organisations guidelines they work out myths and stories to bring down and force

employees into the expected emotional manifestations.

7.6 EMOTIONAL WORK

While the influence of emotions on the functioning of the body (physiological and

physiognomic effects) cannot be influenced or rarely influenced, the regulation of emotions

transmitted through posture, facial expression, gestures or tone is the basis of our social

existence. Organisational members often try to shape their emotional communication in line with

organisational expectations, conceal their true feelings, or simply conceive them. This psychic

conversion process is regarded by the literature as emotional work.

Emotional work is when the individual changes his / her emotions from self-determination,

self-interest, and therefore receives no financial compensation. However, his actions can be

traced back to self-perpetuating behaviour in such cases, since the change of emotions is usually

the goal of compliance with social norms, so the maturity becomes socially compliant.

A distinctive feature of emotional work is that it belongs to the actor's private sphere. Although

there is work in the workplace, the emotional manifestation is decided independently, regardless

of organisational regulation.

For a large part of the staff, however, the volunteer's emotional work is insufficient.

Their daily work involves communicating certain emotions and emotional reactions.

The emotional manifestation of employees is not a private matter at all, but an auditor controlled

by the employer. This is especially true of the service sector, where an integral part of the work is

continuous communication with other people. Everything is public and is a part of the social

construct created by the customer and created by the client.

The emotions that employees feel or pretend to be in the workplace to satisfy the

demands of their work as if they were sensed by the literature as emotional work. In this sense,

emotional work belongs to the official sphere of organisations. Individuals are subject to

organisational expectations. The organisation rewards rewarding emotional manifestations in

accordance with its explicit or implicit rules in the form of salaries or other compensatory


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compensation. From the point of view of the individual and the degree of work done, three forms

of emotional work can be distinguished: Honest, superficial and deep emotional work.

In contrast to emotional work, where dissonance between the expected and actual

emotional states is indispensable, sincere emotional work can also be created by the fact that the

spontaneous emotional reaction of a person to a particular situation is in accordance with the

emotional requirements of the body. Although such in cases, no conscious effort or real work is

done, compensation for the right performance is the right for the employee. The advantage of

sincere emotional work is that the employee meets expectations without realizing the effort, thus

avoiding fatigue and negative psychological consequences while the organisational outcomes are

in line with the effort.

Since the organisation is only able to control the communicable emotions

of the emotionally measured dimension of emotions, the implicit or explicit rules usually refer to

emotional communication. If these rules correspond to the change of non-verbal communication

(facial expression, tone, voice, gestures), that is, emotional manifestations do not coincide with

current emotions, they are doing superficial emotional work. This form of emotional work often

leads to feelings of laziness among employees and can adversely affect performance and work

satisfaction.

While organisational emotional norms only regulate emotional manifestations and

communication, it may be necessary to change emotions for credibility. This is mostly done

through cognitive processes. People with good practice can reproduce appropriate emotions

regardless of the factors that trigger them. In such cases, the negative psychological and somatic

effects on the individual are much more moderate than in the case of surface emotional work.

Organisational standards governing emotional work include social, organisational

and occupational standards, as organisations are embedded systems. Social norms are often

transmitted by customers to the organisation and employees; determine what the good service is

and what the employee needs to do. They write the role that companies are only transmitting to

their employees. From this point of view, emotional work is not an organisation, it is a specific

culture and norm system, and it is not or can hardly be influenced by organisations.


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8. CHANGE MANAGEMENT

The contingencialist approach of organizing and, as well as the need for situational

appropriateness of leadership theory, unanimously draws attention to the need for organisations

to adapt to the world around them. They have to change to survive to achieve their goals.

Adaptation is necessary for all viable organisations in the long run, but the way in which

the change is made has already been decided by the organisation. The changes are basically

three ways to go; reactive, preactive and proactive. While organisations using reactive strategies

are subject to environmental change, preactive organisms are trying to make predictions

of environmental change trends and, in the knowledge of them, shape their future production to

best suit their environmental conditions. Proactive organisations themselves try to influence /

direct environmental factors and induce change in the factors determining organisational

processes.

8.1 ANALYSIS OF THE ORGANISATIONAL ENVIRONMENT

In order for managers to have optimal long-term, strategic decisions, for organisations to

be able to influence relevant environmental elements or to recognize the trends required for

preactive organisational changes, it is necessary to thoroughly examine the organisation's

environment. Without the thorough exploration of external (presented in this chapter) and internal

organisational factors (described in more detail in Chapter 5, 6, 7) strategic decisions cannot be

made.

The organisational environment is broken down into macro and micro environment as

described in the first chapter. The vast majority of organisations do not control the macro

environment, and can mostly only influence the micro environment. Knowledge of environmental

segments and processes is vital to long-term planning.

We can review the macro environment of the organisation through the PEST analysis, in

which we take into account and structure the longer-term environmental trends affecting

companies, thus enabling us to capture the major environmental factors that can influence

strategic decisions. PEST itself is an acronym that contains the following spheres:


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• Political - political

The main focus of the examination of political factors is the national legislature and the

functioning of the parliament, the predictability of economic policy, the content of tax policy,

changes in the laws of competition, laws governing the investments of foreigners, environmental

laws, government policy guidelines, labour law regulations and other corporate there are factors

affecting life directly or through regulators affecting its markets.

• Economic - economical

In the case of economic factors, fundamental economic indicators and characteristics should

be considered: such as GDP, GDP / head, GNP, GDP trends, economic growth or recession,

inflation rate, price level development, interest rate, and the characteristics of financial markets,

trends in investment and accumulation, employment rates, trends in employment and

unemployment. The level of development of the infrastructure and the extent to which it is

investing.

• Social - sociocultural

Socio-cultural factors include all factors that are linked to employees or consumers, or can be

linked to the organisation's basic and supportive processes, products and services. For example,

relevant demographic trends or characteristics of society and national culture.

• Technological - technology

Technological factors include the characteristics of technological infrastructure, and may

include variables for general research and development trends, such as the frequency of the

emergence of new scientific results and their pace of application.

The life and function of organisations are not only influenced by the macro-level environment

but have an impact on the industry or micro-environment relevant to their products, the most

accepted of which is Michael Porter's (1947-) five-forces model.


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Figure 18. Porter’s five forces model

Source: own study

The model assesses the actors of the relevant market environment both from the point of

view of the input-output processes and examines the market bargaining power of suppliers and

buyers, or their realistic power position (dictating or following) in relation to the audited

organisation. Particular attention is paid to the nature of input / output markets (monopoly /

oligopoly / perfect competition) and the resulting balance of power.

However, the model does not only analyse the micro-environment of the organisation,

but also assesses the current market competition by examining competitors. Like buyers

and suppliers, balance of power is at the focus of the investigation. However, the model does not

only want to analyse the potential, but also potential future scenarios, as organisations are a


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much better alternative than a reactive change - a more effective process - a pre-active,

organisational change that precedes environmental change. Investigating potential new entrants,

limiting market competition, and thorough market analysis of substitute products enables

business decision-makers to think about strategic product timing for a organisation's product or

service portfolio.

8.2 CHANGE MANAGEMENT STRATEGIES

When corporate executives are aware of the organisation's relevant environment

and know the internal processes and systems, they are able to decide whether the organisation

needs radical transformation or whether there is enough continuous, incremental renewal

and adaptation.

We consider radical changes affecting all or many of the essential features

of organisations, such as processes, technology, outputs, structure, culture, power relations,

behaviour. Radical changes are needed when promoting the organisation's external adaptation

and / or creating new configurations of organisational subsystem structures and processes.

Radical change is generally rapid, extends to the whole organisation, every hierarchical level,

and involves a large change in the organisation's features.

To make such radical changes successful, there is a need for a precise action plan along

which the top management - with the relatively small changes in the lower levels, - changes fast.

The advantage of radical change is that organisational processes are completely renewed and

inertial systems do not become a barrier to efficiency. The disadvantage is that those who are

seldom involved in planning and decision-making are rarely obliged to change the target

precisely for quick implementation. In the case of radical changes, it is very common for those

concerned not to know the target state of the change, and can only be inferior to the leader's

signals. This is why a great degree of organisational resistance is generated by the members

of the organisation from fear of the unknown.

Most people are uncertain, trying to preserve the status quo even if it is possibly

suboptimal. In the background of fear, both psychological and material reasons can be drawn.

Change, especially radical change, mostly affects material interests, affects the system of powers

and resource allocation schemes, so that more people may face the fear of losing financial


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and life security. This may also be linked to the anxiety that stems from the fact that meeting

our new (unknown) requirements is not yet secure, so it is not guaranteed that our performance,

and our income, will remain unchanged or even change positively. If the change involves

a reorganisation or threatens the existence of a particular organisational unit, the fears will

become more apparent to the affected.

The psychological causes of resistance to change include mistrust, dogmatism, teasing of

power positions, and perceptual filters, which may result in lower levels or changes being

underestimated by the importance or urgency of change and the appropriateness of decision-

making by the leader. This also includes the phenomenon of selective perception when

considering the correctness of our own behaviour as a standard, and rejecting any process

or activity that may challenge its standardisation.

An analogy to leading with agreed achievement targets exists an alternative strategy

of change management that seeks to reduce the fear generated by the involvement of those

concerned by taking into account their opinion instead of rolling resistance. For such incremental

(slow, gradual) changes, not everything is pre-planned, deciding. The initiator of change involves

many people in the process of change both in planning and in decision making - thereby

increasing commitment and reducing resistance to change. Incremental change is particularly

suitable for increasing the efficiency of organisational processes, optimizing systems

and structures.

In the case of incremental changes, only a few important organisational features change

at once, and the extent of change and the range of departments affected are also more limited

than in the case of radical changes. Accordingly, such a change (or initiative) can not only start

from the top management level. In such cases, the change is relatively slow, step-by-step, so the

result is less spectacular, which can be a problem of performance measurement,

on the one hand, and fear from the unknown is less apparent in the process of organisational

members.

Incremental change also allows you to reduce detection distortions. Those affected by

the change do not feel like outsiders, so the dissonance between the images of the need and the

result of the change in the leader and the subordinates may be reduced. Resistance to change

from now on is not based on personal inertia but objective difference of opinion. This may be the


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case when members of the organisational level / unit (not) affected by the change feel limited in

the change and would like to apply uniformly to all organisational units.

Whether it is radical or incremental, organisational change usually involves conscious,

controlled change. The leader / leaders of the change will decide upon the discrepancy between

the current and desirable target status, with regard to the need for change, its focus and the

speed of the change being made. In making this decision, the organisational problem grading

matrix developed by Dwight D. Eisenhower (1890-1969) can help. Critical tasks - precisely

because they are not only important, but also urgent - require immediate intervention. If the

extent of the problem justifies this, the organisational leaders must initiate a radical organisational

change. However, in the case of non-urgent but important issues, you have the ability to design

the process of change with stakeholders. In such cases, the leader (s) have the choice of using a

radical or incremental change management strategy.

Figure 19. Eisenhower matrix

Source: own study

Urgent problems that break the day-to-day work are usually of lesser importance,

management decisions are rarely needed, but management of their ongoing business is

indispensable. For this reason, it is best to delegate the problem of dealing with such problems

as soon as possible. Stakeholders can more easily decide whether the problem is chronic

or acute, and therefore require a system-level change (in this case, it must choose a change

management strategy) or can be handled with one-off and / or programmed decisions (in this

case, and enforcing the task).

Day-to-day work also involves countless less important and less urgent situations and

problems that do not require system-level change management. If the number of daily problems

IMPORTANT NOT IMPORTANT

URGENT Critical problems Interruptions

NOT URGENT Problems that require conscious

planning Daily tasks


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in a particular position is persistently high, it is desirable to look at the job responsibilities and the

competences of the person performing the job.

8.3 CHANGE IN LEADERSHIP TACTICS

Investigating the environmental and corporate characteristics that indicate the need for

change often determines the required change management strategy. However, leaders still have

the opportunity to decide on the change management tactics used. Depending on why and how

much resistance can be expected from the organisational members, who are the most likely to be

expected to do so or whose winning is essential to the change, the leader of the change may

have different positions. In addition to the strength of the stakeholder, the personal characteristics

of the leader and his style of leadership are also decisive when choosing change management

tactics. According to Paul Nutt (1939-), leaders can choose between four types of change

management tactics. For radical change, coercion and intervention tactics are best suited, while

in case of incremental changes, tactics based on participatory and expert persuasion can be

effective.

In the case of compelling tactics, the leader achieves the acceptance of the plan he has

prepared by means of power. The leader decides on the direction and content of the change

in one person and then communicates the tactical plan and the expected way of action and

behaviour to the affected. The leader does not aim to volunteer the stakeholder involved; gives

orders and obeys. The tactic is most effective for authoritarian personality leaders, or in cases

where the maturity of employees is low.

In the intervention tactics, the leader is a person initiator, leader and engine of change,

coordinating the course of change with direct management interventions. Personal involvement

in the process is very high - it designs, organizes, realizes, checks and corrects. The tactic is a

good task for centric executives, as they clearly see organisational processes and their problems.

(Relationship with organisational members is not a focal area during the change (either)).

It is ideal for leaders who prefer group decision making to change their participation

tactics. In such cases, the leader only gives the main direction of the activity and the limits to be

taken into account, leaving the idea to work out and coordinate the change to the creation.

The well-formed decision-making and change management group, with the benefits of the groups


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already discussed, can benefit from a broader acceptance of change, in addition to the benefits

of synergies and multiple perspectives.

Organisational changes may require the involvement of external experts, as strong

organisational culture and organisational inertia hinder the emergence of out-of-the-box solutions

that break new innovative routines. In the case of expert persuasion tactics, the leader relies on

the external experts he calls for the purpose and steps of the change, leaving the process of

change as leader (laisses faire). The task of external experts - beyond the development of the

change plan - is to convince the leader and the pertinent of the correctness of their change

strategy, which is supported by professional arguments.

8.4 THE PROCESS OF CHANGE MANAGEMENT

In the process of change, be it radical or incremental, choose the leader of any change

management tactics, one thing is permanent. Ideally, change is a starting and a final state, and

there is a section between the two, characterized by the dynamic evolution of organisational

power. For this reason, the process of change was Kurt Lewin (1890-1947) using a force field

graph. The model uses end-water comparisons. In the starting state, the body is frozen,

the processes are rigid, unchanged. This situation has to be melted according to the theory

(incremental change), - or, in the case of radical change, the symbolism of a crash would

be a better match - in order for the changes to take place. Water is constantly changing, and the

organisation has to behave like water as it changes. For defrosting, it is essential to disseminate

as broadly as possible the information that makes it possible to understand the situation so that

change can become a viable or even necessary scenario for as many stakeholders as possible.

The third phase of change is a period of stability when appropriate organisational

changes are followed up by new organisational rules, structural elements (division of labour,

division of powers)


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Figure 20. Force-field model of change

Source: own study

When the organisation is in a state of rest, the driving forces behind the change and the

dissuasive forces against change are in balance. In order for the change to begin, the forces

of driving and retention forces must point to change. The above figure, like all models, is

schematic because it represents the organisational forces in only two dimensions. Organisational

processes, however, form a dimensional force field in which each entity - individual, group,

organisational unit - is different. Change in such situations can only be formulated in a two-

dimensional relationship with a given strategic objective, in relation to a given goal.

Ideally, however, the process does not end with the re-freeze phase. The leaders

of the organisation should consciously seek to examine whether the change has enabled

the organisation to reach the status as previously defined and that the environmental

and organisational changes have not yet defined the ideal state to be achieved. The need for

Time

RESTRAINING FORCES

RESTRAINING FORCES

RESTRAINING FORCES

DRIVING FORCES

DRIVING FORCES

DRIVING FORCES

Organisational goal

Status quo

UNFREEZE REFREEZE CHANGE


85

change - in particular in the turbulent economic and technological changes of the 21st century -

must be a constant feature of organisations so that the organisation can achieve its goal - self-

sustaining, serving the interests of the owner and the buyer.


86

References for PART A

- Bar-On, R. (2006). The Bar-On model of emotional-social intelligence (ESI). Psicothema, 18.

- Batchelor, R. (1994). Henry Ford, mass production, modernism, and design (Vol. 1).

Manchester University Press.

- Belbin, M. (2004). Belbin team roles. Book Belbin Team Roles.

- Blake, R., & Mouton, J. (1964). The managerial grid: The key to leadership excellence.

Houston: Gulf Publishing Co.

- Burns, T., & Stalker, G. M. (1961). The management of innovation. London. Tavistock

Publishing. Cited in Hurley, RF and Hult, GTM (1998). Innovation, Market Orientation, and

Organisational Learning: An Integration and Empirical Examination. Journal of Marketing, 62,

42-54.

- Fayol, H. (2016). General and industrial management. Ravenio Books.

- Fiedler, F. E. (1967). A theory of leadership effectiveness. McGraw-Hill Series in

Management.

- Goleman, D. (2006). Emotional intelligence. Bantam.

- Govindarajan, V. (1986). Decentralization, strategy, and effectiveness of strategic business

units in multibusiness organizations. Academy of Management Review, 11(4), 844-856.

- Gunasekaran, A., Irani, Z., Choy, K. L., Filippi, L., & Papadopoulos, T. (2015). Performance

measures and metrics in outsourcing decisions: A review for research and applications.

International Journal of Production Economics, 161, 153-166.

- Hall, J. A., & Knapp, M. L. (Eds.). (2013). Nonverbal communication (Vol. 2). Walter de

Gruyter.

- Hemphill, J. K. (1949). Situational factors in leadership. Ohio State University. Bureau of

Educational Research Monograph.

- Hersey, P. (1984). The situational leader. New York: Warner Books.

- Hersey, P., Blanchard, K. H., & Johnson, D. E. (2007). Management of organizational

behavior (Vol. 9). Upper Saddle River, NJ: Prentice hall.

- Herzberg, F. (2017). Motivation to work. Routledge.

- Hull, P. (2013). 10 Essential Business Plan Components. Forbes, Feb 21, 2013,

https://www.forbes.com/sites/patrickhull/2013/02/21/10-essential-business-plan-

components/#306ad9bf5bfa

https://www.forbes.com/sites/patrickhull/2013/02/21/10-essential-business-plan-components/#306ad9bf5bfa

https://www.forbes.com/sites/patrickhull/2013/02/21/10-essential-business-plan-components/#306ad9bf5bfa


87

- Hunt, J. G., & Hill, J. W. (1969). The new look in motivation theory for organizational research.

Human Organization, 28(2), 100.

- Kaplan, R. S., & Norton, D. P. (2007). Balanced scorecard. In Das Summa Summarum des

Management (pp. 137-148). Gabler.

- Lee, T. W., Locke, E. A., & Latham, G. P. (1989). Goal setting theory and job performance.

- Lewin, K. (1944). A research approach to leadership problems. The Journal of Educational

Sociology, 17(7), 392-398.

- Likert, R., & Likert, J. G. (1976). New ways of managing conflict. New York: McG

- Maslow, A. H. (2013). Toward a psychology of being. Simon and Schuster.

- McClelland, D. C. (1987). Human motivation. CUP Archive.

- Mfondoum, A. H. N., Tchindjang, M., Mfondoum, J. M., & Makouet, I. Eisenhower matrix*

Saaty AHP= Strong actions prioritization? Theoretical literature and lessons drawn from

empirical evidences. IAETSD-Journal for Advanced Research in Applied Sciences, 6, 13-27.

- Mintzberg, H. (1989). Mintzberg on management: Inside our strange world of organizations.

Simon and Schuster.

- Porter, M. E. (1979). The structure within industries and companies’ performance. Review of

economics and statistics, 61(2), 214-227.

- Porter, M. E. (2001). The value chain and competitive advantage. Understanding Business

Processes, 50-66.

- Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard business

review, 86(1), 25-40.

- Taylor, F. W. (2004). Scientific management. Routledge.

- Weber, M. (2015). Bureaucracy. In Working in America (pp. 29-34). Routledge


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List of figures for PART A

Figure1. Schematic graph (configuration) of a single-line organisation ........................................ 17

Figure2. Schematic picture of a multiline, multi dimension organisation ....................................... 19

Figure3. The spheres of the organisational environment .............................................................. 20

Figure4. The characteristics of different structural forms .............................................................. 21

Figure5. The life-cycle and innovation curve of products and services ......................................... 23

Figure6. Organisational processes ................................................................................................ 24

Figure7. The value chain model of organization ............................................................................ 26

Figure8. Basic types of Strategic Business Units .......................................................................... 29

Figure9. Balanced scorecard ......................................................................................................... 31

Figure10. The effect f the leader’s attention on the organisation .................................................. 37

Figure11. Blake-Mouton managerial grid ....................................................................................... 38

Figure12. Schematic model of motivation in organisations ........................................................... 40

Figure13. Indices of organisational performance .......................................................................... 43

Figure14. Schematic model of the process of motivation .............................................................. 46

Figure15. Leadership behaviour in relation to employee maturity ................................................. 60

Figure16. Group roles .................................................................................................................... 65

Figure17. Schematic model of communication .............................................................................. 68

Figure18. Porter’s five forces model .............................................................................................. 78

Figure19. Eisenhower matrix ......................................................................................................... 81

Figure 20. Force-field model of change .............................................................................................. 84


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Appendix 1.

Contents of a Business Plan1

1. Mission statement and/or vision statement so the organization/its leaders can articulate what

they are trying to create;

2. Description of the organisation and its products or services;

3. Description of how the product or service is different from others on the market;

4. Market analysis that discusses the market one is on, or is about to enter, competitors, and

what type of market share one believes to be able to secure;

5. Description of the management team, including the experience of key team members and

previous successes;

6. How one plans to market the product or service;

7. Analysis of the organisation’s strengths, weaknesses, opportunities, and threat, which shows

that plans presented are realistic and have considered opportunities and challenges;

8. Cash flow statement that shows that you understand what the organisation’s needs are now

and will be in the future (a cash flow statement also can help to consider how cash flow could

impact growth);

9. Revenue projections;

10. Summary/conclusion that wraps everything together (this could be replaced by an executive

summary at the beginning of the plan).

1 As recommended by Hull (2013)


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PART B - Business Principles

Jan Vlachý


91

1. THE ROLE AND PRINCIPLES OF FINANCIAL MANAGEMENT

One way of describing the role of managers in firms is to classify their activities into the

following categories:

• Strategic management. This involves developing the aims and objectives for a business

and developing a strategy, i.e. the long-term plan, to achieve them. Normally, strategic

management involves decisions with their impact exceeding the one-year horizon.

• Operations management. This involves applying day-to-day control over the different

business functions to ensure that everything goes according to plan, and taking corrective

action when it does not.

• Risk management. The many different risks faced by a business need to be identified

and properly managed.

These management activities are not perfectly separate and distinct. When considering

a strategy, for example, managers must also carefully assess the risks involved, as well as its

impact on operations.

The finance function plays a fundamental role in each of the three areas. In particular,

financial management involves the following tasks:

• Financial planning. This allows managers to assess the potential impact of strategic

decisions on the future financial performance and health of the firm.

• Investment decisions. These relate to the optimal allocation of available funds in a way that

generates future income.

• Financing decisions. These relate to the optimal acquisition of funds needed to finance the

firm's activities.

• Financial control. This involves the reporting of financial information, which helps monitor

performance and detect when corrective action is needed.

• Other activities, such as capital markets operations, foreign exchange transactions, and

organization of payments.


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There are numerous links between the finance function and the tasks of other managers.

For example, firms' overall strategies always consider financial plans, which, in turn, normally

start from sales projections provided by the relevant departments. Within finance, there also

exists a distinction between strategic (long-term) financial management and operating (short-

term) financial management, each of which closely involves financial risk management.

1.1 STRATEGIC FINANCIAL MANAGEMENT

The primary objective of a firm is generally understood to be shareholder wealth

maximization. This is the main reason for the unique role of financial management. Namely,

it deals with the quantification of wealth, i.e. valuation, which lets managers determine

appropriate strategies to accomplish this key objective2.

It is important to note that wealth maximization is a different criterion from profit

maximization, for several reasons:

• Lack of objectivity. Any profit measure is strongly influenced by particular accounting

policies employed by the firm, such as those relating to depreciation, inventory and bad

debts.

• Time horizon. It is unclear over which period profit should be maximized as, for example,

short term profits may be boosted at the expense of long term profits.

• Risk. The goal of profit maximization takes no account of the risks involved, which,

however, does impact overall wealth, because shareholders are concerned with risk.

• Opportunity cost. Managers can increase their firms' profits by reinvesting current profits

without considering that shareholders could achieve higher returns by investing the funds

in a business with similar risk.

In principle, there are two ways in which shareholder wealth can be measured3. The most

straightforward one considers the price at which the shares can actually be bought or sold.

While attractive due to its simplicity and accuracy, it faces two major obstacles:

2 Tirole (2006, pp. 15-64).

3 Damodaran (2015, pp. 10-14).


93

• Price availability. Many firms, and certainly their business units, do not have their stock

traded or readily quoted on a stock exchange that would make their market price public.

• Price forecasts. Even when the past and current price of stock is known, which allows the

measurement of past performance, it is still hard to forecast future stock prices that would

help assess the impacts of current management actions.

Accordingly, investment wealth is usually determined using intrinsic valuation, which

therefore comprises the fundamental quantitative method used in financial management. Unlike

profit, which is an accounting measure based on historical performance, intrinsic valuation is

forward-looking, deriving value from forecasts of available cash flows in time, while

considering their risk.

1.2 OPERATING FINANCIAL MANAGEMENT

In contrast to strategic financial management, operating financial management deals with

decisions and transactions that have a close-to-immediate impact, typically within the current

year. From the perspective of the firm's entire operations, they typically involve trade and

production, as well as cash and account balances needed to settle operations, and various kinds

of funding needed to finance operations. The aggregate is called working capital.

While working capital management generally focuses on efficiency, i.e. minimizing the cost of

working capital needed for operations, a particular concern of operating financial management is

the firm's liquidity. This expresses the firm's capability to meet all its cash obligations whenever

due.

Even though strategic financial management deals with wealth maximization as the

paramount objective, one may argue that potential lack of liquidity is the ultimate risk a firm can

encounter, as it leads directly to bankruptcy. This highlights the urgent need for expertise in

operating financial management, focusing primarily on the availability of cash and short-term

funding.

Nevertheless, the firm's capability to access additional funds or take corrective action related

to liquidity often depends on its position determined by past strategic decisions, such as raising

long-term capital or determining its structure. Accordingly, it needs to be considered in the


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process of financial planning, which thus becomes a process interconnecting the perspectives

of strategic and operating financial management.

2. FINANCIAL STATEMENTS, CASH FLOWS AND FINANCIAL RATIOS

Financial statements are a standard means of financial control. The statements report

financial information, which helps monitor performance and detect when corrective action is

needed. They are used by firms' management, investors including shareholders, banks and other

lenders, as well as by other stakeholders such as tax authorities or major trading partners.

By definition, financial statements are backward-looking, and therefore less suited as a

resource for valuation or for taking strategic decisions. Nevertheless, subject to necessary

adjustments, they are often used for setting up financial plans and forecasts.

2.1 STRUCTURE OF FINANCIAL STATEMENTS

The vast majority of companies world-wide uses double-entry accounting, which

aggregates financial information in a set of two basic statements, a balance sheet and an income

statement (also called profit and loss account or P&L account). Even though various accounting

standards are used in different countries and for different purposes4, the statements'

fundamental characteristics can be described as follows.

The balance sheet gives an account of the firm's financial position on a particular date.

It has two sides: assets, on the left, and financing, which itself has two parts, liabilities and

shareholders' equity, on the right. Assets and liabilities are normally listed in order of liquidity,

starting with the ones that are considered current, i.e. convertible into cash within one year. The

current assets and liabilities that are used for the firm's operations, on the aggregate, are called

working capital. Combined with operating long-term assets, designated as fixed assets, they

constitute the firm's operating capital.

4 A detailed conceptual comparison is provided by Popatia (2017).


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The difference between the value of assets and liabilities, by definition, is the firm's equity

(or net worth, or book value), consisting of paid-in equity and retained earnings.

Equity = Assets - Liabilities (2-1)

2017 2016 2017 2016

Cash and equivalents 10 12 Accounts payable 23 15

Short-term investments 69 65 Accrued expenses 78 62

Accounts receivable 163 138 Short-term debt 46 33

Inventories 134 119 Long-term debt 90 88

Net plant and equipment 184 167 Equity 323 303

Total assets 560 501 Total liabilities and equity 560 501

Figure 21. Balance sheet (as of December 31, € million)

Source: Emery, Finnerty, Stowe (207, p. 46), modified.

The income statement shows the firm's revenues and expenses during a particular

period. It indicates how the revenues from the sale of product and services are transformed into

net income. This normally takes several steps, first subtracting costs of goods sold, i.e. direct

costs of sales, and SGA (selling, general and administrative expenses), i.e. indirect overheads,

followed by depreciation and amortization. The resulting operating profit or loss (or EBIT, i.e.

earnings before interest and taxes) is followed by the non-operating section, which may include

items not directly related to the firm's primary business activity (such as sale of securities,

disposal of fixed assets or foreign exchange revaluation), but primarily subtracts from EBIT the

costs of financing, i.e. interest expenses, and income tax.


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Sales 547

Cost of goods solid -286

Selling, general and administrative exp. -186

Depreciation and amortization -23

Earning before interest and taxes 52

Interest expense -8

Earnings before tax 44

Income tax -11

Net income 33

Figure 22. Income statement (for 2018, € million)


When companies publish their financial information in the form of an annual report, they

are usually required to include supplementary information, such as a statement of changes in

equity and a multitude of explanatory notes.

When considering information provided in the firm's financial statements, financial

analysis as well as the forecasts that are essential for valuation frequently need to deal with cash

flows, which are not explicit in the basic set of statements. Even though a statement of cash

flows is often part of published information in annual reports, understanding the financial position

of firms requires a working knowledge of the relationship between reported information and its

relation to cash flows5.

2.2 CASH FLOWS

There are several reasons why the revenues and expenses in a firm's income statement

for any period do not usually equate its cash inflows and outflows, and its net income therefore

5 Garrison, Noreen, Brewer (2018, pp. 684-724).


97

differs from its net cash flow. In other words, this is due to the fact that some of the revenues

and expenses were not received or paid during the year. Net cash flow can therefore be derived

from net income as

Net cash flow = Net income - Noncash revenues + Noncash charges (2-2)

The most significant cases of noncash charges are depreciation and amortization.

Depreciation is a method of reallocating the cost of a long-term tangible asset over its useful life

span, while amortization relates to the same concept with intangible assets. Methods of

computing depreciation and the periods over which assets are depreciated may vary between

asset types within the same business, and they may be specified by law or accounting standards.

Depreciation expense generally begins when the asset is placed in service and there are several

standard methods of its computing, including straight-line, fixed percentage and declining

balance.

For example, an asset that initially costs € 10,000 (which is a cash payment) would be

allocated a € 2,000 annual depreciation cost (which is noncash) under a 5-year straght-line

schedule, with a simultaneous decrease of its net value until fully depreciated.

Figure 23. Asset depreciation

Source: own study

Net asset value

1 2 3 4 5 Years

€ 10,000

-€ 10,000

Cash flow


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Depreciation, as well as amortization, reduces net income but is not paid in cash, so it

needs to be added to net income when calculating net cash flow.

In many cases, the other noncash items roughly net out to zero, and therefore many analysts

simply assume that net cash flow equals net income plus depreciation and amortization.

However, to be exact, several other items need to be added and subtracted. They can be

subsumed in three categories6:

• Operating cash flows. Besides adding depreciation and amortization, any net increase in

operating assets (i.e. accounts receivable and inventory) has to be subtracted from, and

any net increase in operating liabilities (i.e. accounts payable) has to be added to net

income, which is the initial operating cash flow.

• Investing cash flows. Any net capital expenditure (CAPEX), i.e. purchases of plant and

equipment net of its disposals has to be subtracted.

• Financing cash flows. Net increase in short-term, as well as long-term debt has to be

added and dividends have to be subtracted.

Reported statements of cash flows usually separate these activities, calculating net cash flow

as the sum of operating, investing and financing cash flows as in Figure 2.4.7 Of course, another

way of determining net cash flow is simply subtracting the amount of cash at the beginning of the

reporting period from that at the end of the reporting period.

6 The list is not exhaustive. For example, investments in securities would be added to investing cash flows, while own stock repurchases reduce cash from financing activities.

7 Note that CAPEX can be determined as the increase in net plant and equipment plus depreciation; paid dividends as net income minus the increase in equity (i.e. retained earnings).


99

Net income 33

Depreciation and amortization 23

Accounts receivable increase -25

Inventories increase -15

Accrued expenses increase 8


Net operating cash flow 40

Purchase of plant and equipment -40

Net investing cash flow -40

Short-term debt increase 13

Long-term debt increase 2

Purchase of short-term investments -4

Cash dividends -13

Net financing cash flow -2

Net cash flow -2

Figure24. Statement of cash flows (for 2018, € million)


However, in financial decisions involving business valuation it is vital to determine

the stream of cash flows that the operations of the business will generate now and in the future,

rather than simply periodical changes of cash on accounts, which can be quite incidental due to

the nonrecurring nature of most financing and investment activities. Such a measure is called

free cash flow (FCF), and it is defined as the firm's after-tax operating profit (NOPAT, i.e. net

operating profit after taxes) minus the amount of new investment in working capital and fixed

assets necessary to sustain the business8.

FCF = NOPAT - Net investment in operating capital (2-3)

8 Damodaran (2015, pp. 516-561).


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This means that free cash flow calculation requires proper determination of the two

components.

Net operating profit after taxes is the amout of profit the firm would generate if it had no

debt and held no financial and other non-operating assets. It can be calculated as

NOPAT = EBIT × (1 - Tax rate) (2-4)

The commensurate tax rate can be estimated from the income statement, dividing

income tax by the firm's total income before taxes. In other words, income tax is allocated

proportionally to operating and non-operating pre-tax income.

Operating capital consists of working capital, which in turn subtracts operating current

assets and operating current liabilities, and operating long-term assets. Net investment in

operating capital over any period can be calculated from the balance sheet by subtracting its

net value at the beginning of the period from that at the end of the period. Note that this already

includes the factor of depreciation.

An alternative way of calculating free cash flow uses the cash flow report, starting with

operating cash flow, adjusted (in contrast to most published cash flow statements) for income

taxes not related to operations, and subtracting net long-term operating capital expenditure

(CAPEX). Put down in detail, this means that

FCF = EBIT × (1 - Tax rate) + Depreciation - Increase in receivables - Increase in

inventory + Increase in payables + Increase in accruals - CAPEX (2-

5)


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Earnings before interest and taxes 52

Income tax (25%) -13

Net operating profit after taxes 39

Depreciation and amortization 23

Accounts receivable increase -25

Inventories increase -15

Accounts payable increase 8


Purchase of plant and equipment -40

Free cash flow 6

After-tax interest expense -6

Net new debt 15

Cash dividends -13

Increase in nonoperating assets -2

0

Figure 25. Calculation and use of free cash flow (for 2018, € million)

Source: Author, based on data from Figures 2.2. and 2.4.

Free cash flow is distributed to investors according to their seniority, beginning with

creditors and followed by shareholders, with the rest remaining as the firm's non-operating assets

such as cash and marketable securities.

2.3 ANALYZING FINANCIAL RATIOS

Financial analysis focuses on techniques determining the firm's financial standing,

typically in comparison to similar firms, to assess financial plans, or in respect to trends

over time. Managers use it to identify situations in need of immediate attention and to assess the


102

impact of decisions in financial forecasts, investors to assess the firm's credit standing or to

estimate fair share value.

One common technique uses financial ratios, which are an essential, quick and

relatively simple tool for the analysis and interpretation of financial statements. They can be

applied to examine various aspects of financial health, and are widely used for planning as well

as control purposes9.

Ratios can be grouped into categories, with each relating to a particular aspect of

financial performance or position. While there is no generally accepted list of ratios, nor a

standard method of calculating many of them, the following ones may be considered useful for

decision-making purposes.

Profitability. These ratios provide an indication of the firm's success in satisfying the

wealth creation objective.

Return on equity = Net income / Equity (2-6)

Return on assets = Net income / Total assets (2-7)

Return on capital employed = Net operating profit after taxes / Operating capital (2-8)

Gross profit margin = (Sales - Cost of goods sold) / Sales (2-9)

Operating profit margin = Net operating profit after taxes / Sales (2-10)

Net profit margin = Net income before extraordinary items / Sales (2-11)

Efficiency. These ratios (also called activity ratios) measure the efficiency with which

particular resources are used by the business.

Receivables turnover = Sales / Accounts receivable (2-12)

Inventory turnover = Cost of goods sold / Inventory (2-13)

Fixed asset turnover = Sales / Fixed assets (2-14)

Total asset turnover = Sales / Total assets (2-15)

Capital intensity = Operating capital / Sales (2-16)



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Most efficiency ratios have reciprocal counterparts and either may be used, under

circumstances. These include average settlement periods, such as for payables or inventory, or

the sales revenue to capital employed ratio. Efficiency ratios can also be based on other types of

resources, besides those reported in firms' balance sheets. For example,

Sales revenue per employee = Sales / Number of employees (2-17)

It should be noted that there is a relationship between profitability and efficiency, and

ratios may be decomposed to identify and manage particular factors determining the firm's

overall performance. The most rudimentary break-down relates to the return on capital employed,

which can be determined by dividing the operating profit margin with capital intensity. This

demonstrates that performance can be enhanced by either increasing the profit margin, or by

decreasing the amount of capital used in operations.

Liquidity. These ratios examine the amount of liquid resources held and available to

meet maturing obligations.

Current ratio = Current assets / Current liabilities (2-18)

Quick ratio = (Curent assets - Inventory) / Current liabilities (2-19)

The right balance of sufficient liquidity without excessive funds tied in cash needs to be

found, differing for different kinds of businesses. The quick ratio is a more stringent test of

liquidity when inventory cannot be quickly converted into cash.

Leverage. These ratios (also called gearing ratios) are concerned with the relationship

between financing by the owners and that in the form of loans which have to be repaid,

constituting a financial risk for the firm. Alternatively, as with the interest coverage ratio, they may

consider the capacity to service the costs of debt.

Debt ratio = Total debt / (Total debt + Equity) (2-20)

Interest coverage ratio = EBIT / Interest expense (2-21)

Investment. These ratios assess the performance of shares in a business from the perspective

of shareholders not involved in its management.

Dividend payout ratio = Dividend payout / Net income (2-22)

Dividend yield = Dividend payout / Market capitalization (2-23)


104

Price/earnings ratio = Market capitalization / Net income (2-24)

Price/sales ratio = Market capitalization / Sales (2-25)

Price to book ratio = Market capitalization / Equity (2-26)

Most of the investment ratios relate to market capitalization, which is a value determined by

multiplying the number of outstanding shares by the stock price, and can be considered an

estimate of the firm's market value.

3. INTRINSIC VALUE

Intrinsic valuation is based on the premise that any asset's value derives from its potential to

generate future earnings10. Furthermore, investors' demand will be influenced by their

opportunity cost of investing in other assets with a comparable risk characteristic.

The intrinsic value concept relates closely to the time value of money principle. There

are principally three reasons why most people and investors do not normally see an amount paid

now as equivalent in value to the same amount being received at a later time. They include the

opportunity cost of potentially making another profitable investment, the perceived risk in the

investment which should be compensated by a risk premium, and the expected loss in the

purchasing power of money, i.e. inflation.

Considering these factors in aggregate, as an opportunity cost of undertaking

an investment in the current market environment and with a commensurate risk

characteristic, which we shall designate c, this quantity defines a relationship between the

present value PV and the future value FV of any payment as

FV = PV (1 + c) (3-1)

The opportunity cost c is periodical, and different investment time horizons therefore

result in its compounding, with a generalization of Equation (3-1) as

10 Damodaran (2006, pp. 516-561).


105

FVt = PV (1 + c)t (3-2)

To illustrate, depositing the amount PV = €10,000 with a bank paying interest c = 4% will

result in a balance FV1 = €10,000 (1 + 4%) = €10,400 by the end of the first interest-paying

period, and FV2 = €10,000 (1 + 4%)2 = €10,816 by the end of the second interest-paying period.

Note that in this particular case we are considering an actual investment yield; however, the

same value would be considered opportunity cost for alternative comparable investments.

When applying the time value of money framework for intrinsic valuation, present values

are calculated from future values, resulting in a reformulation of Equation (3-2) as in (3-3), where

the more common designation V (as value) is used instead of present value and CFt designates

the expected future cash income at time t (in years, assuming c is defined on an annual basis).

V = CFt / (1 + c)t (3-3)

Another term used for the valuation approach described in Equation (3-3), reverse

to compounding, is discounting the future cash flows, and the opportunity cost c is therefore

also called discount factor.

Usually, assets that need to be valued comprise multiple cash flows projected at

different points of time. Furthermore, any of the future cash flows may take negative and positive

values, CFt thus representing cash outflows as well as inflows in time. A typical case concerns

capital budgeting projects such as the construction of a production plant, which begin with cash

outflows at the time of construction, followed by net cash inflows due to the proceeds of selling

produced goods exceeding periodical expenses.

The value of such a general cash flow stream is simply the sum of all discounted cash

flows, positive or negative, called their net present value (NPV):

NPV = ∑𝐶𝐹𝑡

(1+𝑐)𝑡𝑁𝑡=0

(3-4)


106

Even though Equation (3-4) constitutes a universal intrinsic valuation formula, its application is

not always practical, and it is then convenient to use one of the specific models described in the

following paragraphs11.

3.1 ANNUITIES

An annuity, by definition, is a series of cash flows made at fixed intervals and equal

in size. This is typical for assets such as bonds, as well as obligations including consumer loans,

mortgages, rental lease payments or insurance premiums.

Based on the timing of the initial cash flow, one may distinguish between three types of

annuity:

• Ordinary annuity. The cash flows occur at the end of each period.

• Annuity due. The payments are made at the beginning of each period.

• Deferred annuity. The initial cash flow is due at a different point of time in the future,

usually at the end of the second or a subsequent period, i.e. deferred by one or more

periods.

The most common ordinary annuity (or, simply, annuity) thus features cash flows as

illustrated in Figure 3.1. a), for the case of a 5-period annuity, compared to the annuity due

shown under b).

Figure 26. Cash flows of a 5-period annuity

Source: Vlachý (2018, p. 37), modified.

11 More detailed derivations are available in e.g. Capiński, Zastawniak (2003, pp. 21-38).

2 1

a) Ordinary annuity

4 3 7 6 0 1 2 3 4 5 0 5 6 7

b) Annuity due


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Annuities are characteristic in featuring a linear relationship between their present value

V and the periodical payments PMT described by

AnnuityV = AF × PMT (3-5)

The value AF, called annuity factor, depends solely on the number of annuity periods N

and the periodical discount rate c, and can be calculated as

AF = (1 / c) - 1 / [c × (1 + c)N ] (3-6)

Once an ordinary annuity payments stream can be valued according to Equations (3-5)

and (3-6), it is then simple to solve other problems relating to annuities.

Annuities due have a higher value compared to ordinary annuities, because each of the

payments gets pushed forward by one period, and therefore appreciate by exactly one

compounding step:

AnnuityDueV = AnnuityV × (1 + c)

In contrast, deferred annuities put away each payment by one or more, generally D,

periods, with a corresponding discounting of value as in

DeferredAnnuityByDPeriodsV = AnnuityV / (1 + c)D

Finally, it is possible to calculate the projected future value of any annuity with a known

present value at a future point of time using Equation (3-2).

3.2 PERPETUITIES

An annuity with an infinite flow of payments is called perpetuity. Even though, strictly

speaking, it may seem unrealistic to consider any projection of payments or revenue perpetual,

it is often practical to use such a conceptual model in cases such as sustainable free cash flows

from a mature business, or the yields from non-redeemable preferred stock.

It is possible to derive a perpetuity valuation formula by setting N ―> ∞ in Equation (3-5),

which conveniently results in the simple Equation (3-7)


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PerpetuityV = PMT / c (3-7)

Another useful equation can be derived for perpetuities whose payments are not

constant, but growing by the factor g, with PMTt = PMTt-1 × (1 + g). The value of such so-called

growth perpetuities with the payment PMT1 occuring at the end of the first period can then be

calculated12 as

GrowthPerpetuityV = PMT1 / (c - g) (3-8)

For example, a stream of perpetual annual payments of €10 and 10% annual opportunity

cost would therefore have a 10 / 10% = €100 present value. Assuming a 5% annual payments

growth, the value would increase to 10 / (10% - 5%) = €200.

It is to be noted that, mathematically, c always needs to be greater than g. However, Equation

(3-8) can also be used for valuing diminishing payments, i.e. ones with a negative g.

3.3 DIFFERENT COMPOUNDING PERIODS

It is important to recognize that any of the relationships between returns, and present and

future values, discussed in the present chapter assume consistent time horizons. For example,

the annuity factor calculated in Equation (3-6) with N = 12 and c = 2% may relate to an annuity

with 12 annual payments, provided the annual return is 2%, as well as a 3-year annuity paid

quarterly, where the 2% return would be quarterly, or a 1-year annuity with monthly payments

and a 2% monthly return.

This means that it is often necessary to convert equivalent returns for different time

horizons. In other words, we are looking for values of c that would give equal future values FVt for

different compounding time horizons t in Equation (3-2), i.e. FVt1 = PV (1 + c1)t1 = FVt2 = PV (1 +

c2)t2, which rearranges as

c2 = (1 + c1)t1/t2 - 1 (3-9)

A monthly return of c1 = 2%, where t1 = 12 (compounding periods per year) would thus

equate to a quarterly (t2 = 4) return c2 = (1 + 2%)12/4 - 1 = 6.12%.

12 Gordon, Shapiro (1956).


109

The equivalent return on an annualized basis (when t = 1), which is normally used as a

benchmark, is called effective annual return. In the current case, its value would be EAR = (1 +

2%)12 - 1 = 26.82%.

This needs to be distinguished from the nominal annual return (or nominal interest rate),

often quoted by banks, which simply sums all percentage returns in a year without considering

compounding. For a 2% rate per month that would mean a 12 × 2% = 24% nominal interest rate

(note the substantial 2.82% difference when compounding is taken into account).


110

4. CAPITAL BUDGETING DECISIONS

Managers often consider decisions that involve an investment outlay today in the hope

of realizing future incomes. Such decisions, ranging from purchases of new equipment or its

replacements to the introduction of new products or distribution channels, constitute a critical

factor in the capability of the firm to create wealth for its shareholders.

The relevant decision-making process is called capital budgeting and may involve various

kinds of situations, such as:

• Expansion decisions. Should a new plant, warehouse, or other facility be acquired to

increase capacity and sales?

• Cost reduction decisions. Should new equipment be purchased to reduce costs?

• Equipment selection decisions. Which of several available machines should be

purchased?

• Equipment replacement decisions. Should old equipment be replaced now or later?

Capital budgeting decisions fall into two broad categories, screening decisions

and preference decisions.

Screening decisions relate to whether a proposed project is acceptable on a stand-alone

basis, using a suitable criterion. Because wealth maximization is the firm's overall objective,

screening is based on whether the project increases the value of the firm. By definition, this is the

case for projects which return a positive net present value. Provided the project decision is

independent of any other, it is therefore sufficient to calculate the net present value

of the forecasted project cash flows and accept all projects that have NPV > 0. Practitioners

sometimes use different criteria (such as payback, accounting rate of return, internal rate

of return, or profitability index), but they are either methodically inferior, or give identical results.

Preference decisions, in contrast, require a selection from several alternatives that would

otherwise pass a screening decision. This means that the projects are mutually exclusive. Such

a situation may arise due to various reasons. For example, a company may be considering

several different machines to replace an existing one on the assembly line, or several new


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product launches are being considered under the constraint of a limited capital budget or another

scarce resource, such as a skilled workforce. Under circumstances, different methods can be

used to resolve such problems.

Summarily, the following steps are normally taken when managing investment projects in

a professional business environment:

1. Determine investment funds available, dealing, if necessary, with capital rationing issues;

2. Identify projects with a potential to enhance shareholders' wealth;

3. Refine and classify the projects;

4. Evaluate proposed projects;

5. Approve the projects;

6. Monitor and control the projects, making necessary adjustments when necessary.

4.1 SELECTING INDEPENDENT PROJECTS

For screening, the fundamentally sound decision-making criterion is accepting projects

with a positive net present value, which directly determines their value-enhancement

potential13. For example, a project starting with an initial investment of €1,000 and anticipating

€200 net cash inflows in each of the following eight years would pass, assuming an 8%

opportunity cost of capital, because of its positive NPV = €149.

Another widely used measure is the internal rate of return (IRR). It can be defined as

the cost of capital that, when applied to the future cash flows of a project, will produce a net

present value exactly equal to zero. In other words, it meets the following condition, derived from

Equation (3-4):

0 = ∑𝐶𝐹𝑡

(1+𝐼𝑅𝑅)𝑡𝑁𝑡=0 (4-1)

In essence, IRR represents the annualized yield from an investment opportunity

and investments should be accepted which have an IRR exceeding the opportunity cost c.

13 Emery, Finnerty, Stowe (2007, pp. 221-222).


112

In most real-life cases, IRR cannot be calculated by a closed-form rearrangement of Equation (4-

1), but needs to be figured out numerically, using iteration.

The internal rate of return has two convenient features. In the first place, it does not

require a precise estimate of the opportunity cost of capital (which may be difficult), stipulating

that the internal rate of return should simply be "sufficiently high", usually exceeding an arbitrary

value which the firm stipulates as its hurdle rate. It also allows adjustments of the hurdle rate,

based on policies or constraints regarding the number of projects the firm is capable or willing to

realize at a particular time.

The IRR in the problem above is 11.81%, and the project may therefore be accepted,

provided the firm is confident that its opportunity cost of capital lies below this value. However,

it would still be declined if management set its hurdle rate at 15% in order to constrain project

acceptance.

The internal rate of return criterion has several weaknesses. Above all, it does not directly

address the objective of maximizing wealth generation. When used for the ranking of projects,

it can therefore lead to the wrong decision, prioritizing a project with a lower NPV. This is

because the measure ignores the scale of investment. A further problem with using IRR relates to

its being ambiguous for projects with unconventional cash flow streams14.

Some managers base their decisions on the payback criterion. This simply considers the

time needed for an initial investment to be repaid out of the net cash inflows from a project.

The problem above thus has a payback of 5 years. Aside from its simplicity, however, payback

suffers from at least two major deficiencies. Firstly, it ignores the time value of money,

and secondly, it disregards any cash flows, positive or negative, beyond payback. Rather than for

taking substantial decisions, it is therefore only useful for project pre-screening, at best.

14 Such a project may have more than one IRR over its life, as explained by Hartman and Schafrick (2004).


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4.2 SELECTING MUTUALLY EXCLUSIVE PROJECTS

Projects with a positive NPV should be undertaken if the business wishes to maximize

shareholder wealth. However, sometimes investment funds are limited. In such a case, not all

projects with a positive NPV can be undertaken and the rule requires modification to provide for

optimal capital rationing15.

The most simple approach uses a measure that represents the efficiency of funds

invested in the project, which is called profitability index (PI). It is calculated by dividing the

present value of all future cash inflows by the initial investment outlay I0 (= CF0) of the project

PI = Present value of future cash flows

Initial investment (4-2)

Obviously, independently considered projects with NPV > 0 will have PI > 1, and in this

context using the profitability index brings no additional benefit. However, it is a useful tool

for capital rationing when projects are ranked according to their profitability indices

and accepted until the capital budget constraint is reached. This ensures the highest possible

cummulative NPV from the funds available for investment.

This approach has a limitation when the total investment does not perfectly add up to the

capital constraint, i.e. when the marginal project is not scaleable (or the projects are not

sufficiently small to make the effect negligible). Other combinations of projects using more of the

available capital may then yield a higher net present value, and should be selected. Generally,

such problems can be solved using linear programming.

For example, the firm may consider three projects, requiring initial investment outlays AI0

= €4, BI0 = €3, CI0 = €5, and providing present values of future cash inflows APV = €5.8, BPV =

€4, CPV = €7. It can be easily determined that their ranked profitability indices are API = 1.45 >

CPI = 1.40 > BPI = 1.33. Assuming the capital budget is constrained by €9, projects A and C with

the highest profitability indices should be selected. However, provided the limit would be €8, this

method only allows investment in A (unless C could be downsized to €4), bringing an ANPV = 5.8

- 4 = €1.8. This contrasts with an investment combining B and C, which actually have the lowest

15 Damodaran (2006, pp. 227-283).


114

profitability indices (still higher than 1), but provide a higher aggregate B+CNPV = 4 + 7 - 3 - 5 =

€3.

Firms may also find themselves in a position when they have to decide between two or

more competing investment projects aimed at meeting a continuous need and having different

life spans. Such situations are called replacement chains. Again, the proposal with the highest

stand-alone NPV need not be optimal, because a shorter life frees up capital and gives

opportunity to reinvest sooner in another project with a positive net present value16.

There are two ways to tackle this problem. One simply considers the equipment to be part of a

repeat chain of replacement and compares the alternatives based on their total NPV over the

shortest common period of time.

The other, and more universal one, also uses a common time horizon, but this time the

period is one year. The method uses the annuity concept, converting the project's net present

value into an annual annuity payments stream over its expected life. The criterion for selecting

the highest-value project is called equivalent annual annuity (EAA) and its calculation derives

from Equations (3-5) and (3-6) as

EAA = NPV / AF (4-3)

For example, we may consider alternative two- and three-year investments with 2NPV =

€100 and 3NPV = €150. Assuming a discount rate c = 10%, one solution considers a choice

between three consecutive 2-year investments, which have an aggregate 3×2NPV = 100 + 100 /

(1 + 10%)2 + 100 / (1 + 10%)4 = €250.95, and two consecutive 3-year investments, with 2×3NPV =

150 + 150 / (1 + 10%)3 = €262.70. Having the highest NPV over the six years, the second option

should be selected.

Alternatively, equivalent annual annuities can be used. While a two-year project has an

annuity factor 2AF = (1 / 10%) - 1 / [10% × (1 + 10%)2] = 1.74, and therefore 2EAA = 100 / 1.74 =

€57.6, the three-year project uses an annuity factor 3AF = (1 / 10%) - 1 / [10% × (1 + 10%)3] =

2.49, resulting in 3 EAA = 150 / 2.49 = €60.3. Based on its highest annualized value, the second

option should thus also be selected, consistently with the common investment horizon method.

16 Brigham, Ehrhardt (2011, pp. 406-408).


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5. PROJECT CASH FLOWS

In order to make correct capital budgeting assessments, decision-makers need to estimate

the two distinct types of variable appearing in the net present value-determining Equation (3-4).

Namely, they are the opportunity cost of capital, addressed in Chapter 7, and the periodical cash

flows which will be discussed in this Chapter.

5.1 FORECASTING CAPITAL BUDGETING CASH FLOWS

The only relevant cash flows that should be taken into account when appraising capital

budgeting decisions are the ones that can be impacted by the decision being assessed. This

simple principle implies several important points to bear in mind:

• Sunk costs. All past cash flows (such as the costs incurred in research) must be ignored,

because they cannot be influenced by the decision. The same regards irrevocable

commitments, even if the payment is due in the future.

• Differential cash flows. Any future cash flows that do not vary with the decision are

irrelevant. In the case of preference decisions, it is therefore sufficient to consider the

differential cash flows only and select the alternative which, compared to all others, shows

a positive net present value.

• Opportunity costs. Any potential benefits foregone by the decision must be taken into

account as an opportunity cost.

• Taxation. The value of projects is usually impacted by taxation, sometimes to a substantial

degree. All cash flows therefore need to be assessed on an after-tax basis.

Assume, for example, that there is an opportunity to spend €100,000 in order to save €6,000

perpetually on an existing project, with a 5% opportunity cost of capital and a 20% tax rate. In the

first place, it is completely irrelevant what the project has cost in the past, as that is a sunk cost.

Second, it does not matter what the forecasted cash flows actually are, because the project being

considered just impacts the difference in cash flows. Finally, the annual €6,000 saving will


116

increase operating income by the same amount, resulting in a 20% × 6,000 tax liability. Upon

applying Equation (3-7), the project therefore has an NPV = (.80 × 6,000 / .05) - 100,000 = -

€4,000 and should be declined.

It may be noted that any decision, including screening, can be posited as a selection

between alternatives, because there always exists the option of taking no action.

Essentially, cash flows must always be taken into account, rather than accounting values,

and their timing has to be estimated properly. Also, any cash flows related to costs of financing,

such as interest payments, may not be included, because they are already being considered as

an opportunity cost by means of the discount rate.

Starting from these fundamental rules, it is usually necessary to consider several distinct

categories of forecasted cash flows when considering capital budgeting projects:

• Net initial investment outlay. Usually appears at the beginning of the project, and can be

positive as well as negative (when disinvestments are considered). It should include cash

expenditures for new capital assets, changes in net working capital, sale of any assets

being replaced, as well as possible tax impacts.

• Net operating cash flows. Normally appear as recurring over the whole useful life of the

project, and must include the taxation of operations.

• Non-operating cash flows. They can occur at various points during the life of the project,

and may include repair or overhaul costs, changes in working capital, insurance charges

etc.

• Net salvage value. Is the after-tax net cash flow from terminating the project at the end of

its useful life, and normally includes the proceeds of asset sales, cleanup and removal

expenses, release of working capital, and tax impacts.

Accordingly, one may assess a replacement project as follows: The firm currently uses

equipment with a remaining 4-year useful life, after which it would be fully depreciated and

operationally worthless. Its annual depreciations are €10,000 and it can now be sold for €30,000.

A replacement is being proposed, with a new and more efficient machine that would cost

€140,000, depreciated straight-line over seven years. After four years it is expected to have a

value equal to its book value. It would save the firm €24,000 annually in operating costs and


117

decrease the need for inventory by €30,000. The firm's tax rate is 25%, its opportunity cost of

capital is 8%.

The net initial investment outlay cash flows include purchase of the new equipment

(-€140,000), sale of the old equipment (+€30,000), its tax impact due to the fact that the sale is

below a book value of €40,000, i.a. at a €10,000 loss (the firm saves 25% × 10,000 = €2,500 tax,

which is a positive cash flow), and the release of cash from inventory worth €30,000.

The difference in operating cash flows in each of the four years will be +€24,000, but these

have to be adjusted by the 25% × 24,000 = -€6,000 tax liability. The firm will also charge €20,000

depreciations, resulting in a 25% × 20,000 = +€5,000 tax saving. On the other hand, because of

its sale, it will lose the entitlement to depreciate the old equipment, and therefore have to pay

25% × 10,000 = -€2,500 more tax compared to the alternative of keeping it in on the books.

Finally, in four years time, the firm will be able to sell the new equipment (+€60,000), with no

tax impact, as the expecting selling price is equal to the book value. There also needs to be a

reversion of the initial working capital adjustment to its initial state, meaning a negative cash flow

of -€30,000, because if the old equipment were retained, the cash would have been released at

this point of time.

Summarily, the project cash flow forecasts are CF0 = -€77,500, CF1 = CF2 = CF3 = €20,500,

and CF4 = €50,500, which gives a positive net present value NPV = €12,450 when comparing the

alternatives of replacement with non-replacement. The equipment should therefore be replaced.

5.2 UNCERTAINTY IN PROJECT CASH FLOW FORECASTS

One major issue concerning the forecasts of future cash flows in capital budgeting projects

relates to the uncertainty in their estimates17. The risk may be due to external, as well as internal

factors. It is particularly important when projects involve large capital budgets and long time

horizons. In such cases, it may be useful to employ methods assessing this risk. Broadly, they

can be categorized in two groups, sensitivity analysis and scenario analysis18.

17 Anderson, Sweeney, Williams (2016, pp. 622-627).

18 Mun (2006, pp. 142-151).


118

Sensitivity analyses study how the project's net present value would be impacted due to

changes in the estimate of a particular risk factor. Risk factors are the values that need to be

forecasted in order to make the cash flow estimates, and - under circumstances - may include

variables including the number of product units sold, the selling price, various cost components,

efficiency-related parameters such as claims and spoilage, but also interest, exchange or tax

rates.

It is characteristic of sensitivity analyses that NPV sensitivity towards any single factor is

investigated, assuming all other forecasts remain unchanged. For example, we may find that a

decrease in forecasted unit sales by 10% may reduce NPV by €3.2 million, that of 20% by €6.4

million, etc. On the other hand, if energy costs are 10% higher than expected, this may reduce

NPV by €1.4 million, while a 20% increase would reduce NPV by €2.8 million.

There are two common ways to display sensitivity analysis results. Setting up and

interpreting a tornado diagram is easier, because it simply consists of horizontal bar charts

comparing the NPV changes based on equal relative changes, positive or negative (such as -

10% and +10%), of each risk factor, ranking them vertically from highest to lowest.

Figure 27. Tornado diagram


4,000 3,000 2,000 2,000 1,000 1,000 3,000 4,000

-€ €

0

Unit price

Unit sold

Unit costs

WACC

Tax rate


119

A sensitivity graph charts the complete functional relationships between percentage

changes in each factor and the corresponding NPV changes. A steeper slope of a function

indicates higher sensitivity. This is a more computionally demanding approach, but provides

deeper insights on the risk profiles, in particular when some of the functional relationships are not

linear.

Figure 28. Sensitivity graph


It is also possible to calculate break-even points. These are defined as the value of any

risk factor that would result in the project's net present value exactly equal to zero. It is usually

easy to calculate them using iteration. Break-even analysis appeals to many managers, because

it provides them with an intuitively coherent measure of the margin of safety in a project.

For example, a project proposal can forecast 300,000 product unit sales every year, resulting in a

positive net present value, but it would still break even when only 220,000 units are sold.

This may provide the ultimate decision-makers with sufficient confidence to approve the proposal.

-30% -20% -10% 30% 0% 20% 10%

€ 2,000

€ 4,000

€ 6,000

€ 8,000

€ 10,000

-€ 2,000

-€ 4,000

-€ 6,000

-€ 8,000

-€ 10,000

Unit price Unit sold Tax rate WACC Unit costs


120

Whatever its form may be, sensitivity analysis is useful to assess and compare the

relative impacts of particular risks. Its findings can then be used to make adjustments to project

proposals improving their risk characteristics, or take decisions on mitigation strategies

and contingency plans.

In contrast to sensitivity analyses, scenario analysis considers more complex - and thus

realistic - situations when more variables are changed simultaneously to provide a particular

scenario. A number of such possible state of the world can be presented to managers, with each

drawing attention to variables that are vital to a project's success. Sometimes, generally

conceived optimistic, pessimistic and most likely scenarios are developed, while an alternative

approach prefers to focus on the consequences of particular events, such as a downturn i

n the business cycle, bad weather, or a supply chain disruption.

Statistical simulations (sometimes called Monte Carlo simulations) are an extension

of scenario analysis in that a complete distribution of key factors in the project is created

and a computer uses random number generation and a valuation model to calculate a multitude

of possible scenarios, which can then be thoroughly analyzed using statistical methods19.

This facilitates a much better understanding of project risks than either simple scenatio analysis,

or sensitivity analysis.

19 Mun (2006, pp. 73-85).


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6. FINANCIAL PLANNING

In contrast to capital budgeting, which concerns individual project decisions and tends to be

decentralized in most firms, financial planning relates to firms' overall strategies. Long-term

planning falls under the direct authority of senior management, often under close shareholders'

supervision.

Any business needs to develop plans for the future and finance lies at the heart of the

planning process. To ensure that limited resources are used as effectively as possible, managers

must carefully evaluate the financial implications of each possible course of action.

Developing plans for a business involves the following consequential steps:

• Setting the aims and objectives of the firm. The primary objective is usually

maximisation of shareholder wealth.

• Identifying the available options. Looking in the long term, these options would

constitute various possible strategies.

• Selecting an option (strategy) in the context of developing long-term plans. Each will be

considered with an assessment of the impact on future financial standing.

• Developing short-term plans. Ensures that day-to-day management decisions

and actions are consistent with the long-term plans.

Financial forecasts play a vital role in the final two steps of the planning process:

the evaluation of long-term strategies and the development of short-term plans. All three

main financial statements, i.e. a projected balance sheet, a projected income statement

and a projected cash flow statement may be used for planning purposes. So-called pro-forma

(or forecasted) financial statements, used primarily for long-term planning, then provide

a comprehensive picture of the expected future financial position, profitability and liquidity,

facilitating comparisons between the different strategies.

Broadly speaking, the statements employ similar methods and principles used

for conventional financial statements. In principle, however, short-term projections tend to focus

on the cash budget, because of the prevailing concern about liquidity, while long-term forecasts

concentrate on the balance sheet, due to its representation of value.


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There is also a difference between preparing pro-forma statements for relatively short,

and long time horizons. While it is often viable to prepare them in some detail in the shorter term,

simpler and less detailed statements are usually provided over longer periods, when less reliable

information is available and the costs of preparation would be inadequate.

The performance and position revealed by the projected financial statements always needs

to be critically examined. On the one hand, managers should always ask how the projections

were developed, what underlying assumptions were made and whether all relevant items have

been included, i.e. whether the forecasts are reliable. On the other hand, they need to be

confident that the firm's development under the plan is sustainable by asking questions such as:

• Are the cash flows satisfactory to meet all commitments, including contingencies?

• Is there a need for additional financing and is it feasible to obtain?

• Is the level of borrowing acceptable in terms of the firm's standing with creditors?

• Is the return on shareholders' investment satisfactory in relation to the returns involved?

• Does the firm use its assets efficiently?

The sustainability assessment can be made by analyzing financial ratios calculated from the

pro-forma statements, and making adjustments to the plan when necessary. Financial planning

therefore constitutes a process of evaluating the impact of alternative investing and financing

decisions, often with multiple feedbacks, as illustrated by Figure 6.1.


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Figure 29. Interaction of financial planning decisions

Source: Emery, Finnerty, Stowe (2007, p. 703), modified

Property, plant and equipment

Output

Inventories

Operating income

Net income

Retained earnings Dividends

Cash flow from operations

Internal cash generation

External funds requirements

External equity requirement

Net borrowing requirement

Debt repayment

Variable inputs

Demand

Capital budget

Long-term debt

Terms of issues

Total debt

Additional short-term debt

Capital expenditure

Sales revenue

Taxes

Interest expense

Noncash charges

Capital budgeting policy

Capital structure policy

Liquidity policy

Financing policy

Working capital increase


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Financial plans are updated on a regular basis, according to a planning cycle.

Each update appends the latest available information and renews the planning horizon. This is

one year or less for short-term plans and usually around five years for long-term plans, even

though this horizon may be substantially longer for some industries. Short-term plans may be

updated monthly, weekly, and even daily, long-term plans are usually updated annually

or quarterly.

6.1 FINANCIAL FORECAST

The starting point with most financial forecasts is a forecast of sales. Sales are a factor

that normally sets a limit to business growth and determines the level of operating activity.

When forecasting sales, conditions of the general economy, industry and competition are

considered. Approaches may be qualitative, such as sales force polling, expert panels

or consumer surveys, as well as quantitative, ranging from trend analyses to econometric

models. Often, seasonality (for short-term plans) or business cycles (for long-term plans) need to

be considered.Cash Budgeting

The most common tool of short-term financial planning is the cash budget, which

forecasts the firm's cash inflows and outflows during the planning horizon20. That allows

projection of cummulative cash balances and the planning of short-term transactions used to

cover cash shortfalls or use cash surpluses. A positive net cash flow can increase the cash

balance, reduce outstanding loans, finance the purchase of short-term liquid securities, or be

used elsewhere in the business. Conversely, negative net cash flows can reduce cash, or be

offset with additional borrowing or the sale of liquid securities.

Cash inflows are usually tied to sales, but also depend on the proportion between cash

and credit sales, where, in turn, the time delays involved in collecting depend on credit terms

and payment patterns. Some variable cash outflows, such as materials purchases or energy,

also usually depend on sales, while other cash expenditures, such as rent payments, are fixed

and do not fluctuate with current sales.



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A simple example of a monthly cash budget can be illustrated as follows: A firm currently

(at year's beginning) has a €10,000 cash balance, which it considers minimum, while it does not

want to hold cash exceeding €20,000. Its cash sales are expected to be €80,000 in January,

growing by 3% every month, except July and October, when sales fall by 60%, reverting

to the June sales in November. Variable costs amount to 40% of sales, paid on 30-day credit,

fixed monthly costs (excluding depreciation) are €40,000. In March, a tax liability of €18,000 for

the previous year will have to be paid, and a new machine will be purchased for €50,000 in June.

The following Figure shows the free cash flow, as well as cummulative cash forecast from

operations for the next 12 months:

Figure 30. Monthly cash budget

Source: own study

Decisions then have to be taken and cash flows included in the budget regarding short-

term financial transactions. In compliance with its cash management policy, the firm may

consider negotiating a 4-month €10,000 deposit from February, additional deposits in April and

May, followed by a 2-month loan, etc.

Some of the cash flows in a cash budget tend to be quite predictable, while the timing of

others is rather uncertain; this requires firms to hold cash in precautionary reserve, as explained

in the context of working capital management in Chapter 8.

0 1 2 3 4 5 6 7 8 9 10 11 12

Cash 10,000 18,932 29,332 23,244 36,713 51,787 18,512 -2,939 -9,552 20,932 39,539 59,539 81,525

Sales 77,670 80,000 82,400 84,872 87,419 90,041 92,742 55,654 55,645 92,742 95,524 98,390 101,34

Variable cost -31,068 -32,000 -32,949 -33,949 -34,967 -36,016 -37,097 -22,258 -22,258 -37.097 -38,210 -39,356

Fixes coast -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000 -40,000

Tax -18,000 -50,000

NCF 8.932 10,400 -6,088 13,469 15,073 -33,274 -21,452 -6,613 30,484 18,427 20,180 21.986


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6.2 LONG TERM FINANCIAL PLANNING

Two methods are commonly used for long-term planning over one year: the percent of

sales method, which is the simplest one, and full forecasted financial statements.

The percent of sales method (often called AFN, for Additional Funds Needed) is a crude

but practical way to estimate the funds required to finance growth21. It is much easier to apply

than forecasting the complete financial statements, but provides only balance sheet forecasts.

Its main assumption is that any growth in sales requires a growth of operating assets, i.e.

trade receivables, inventory and fixed assets. At the same, some working capital financing arises

spontaneously, through an increase of trade payables and accruals. Additional financing comes

from earnings retention. Any remaining financing that is needed must come from other sources,

such as additional borrowing or issuing new equity. Accordingly it is possibly to calculate net

additional external financing as

Additional financing needed = Required increase in assets - Increase in liabilities -

Increase in retained earnings (6-1)

In its simplest form, the method takes the following assumptions:

• Expenses including taxes can be expressed as a fixed percentage of sales; in other words,

the net profit margin on sales m remains constant.

• All operating assets (i.e. current assets and non-current assets) can be expressed as a

constant percentage of sales OpA / S.

• Operating current liabilities (trade payables and accruals) are spontaneously growing

and can be expressed as a constant percentage of sales OpL / S.

• The dividend payout ratio p remains constant.

Forecasting any periodical growth rate in sales g = (St - S0) / S0, Equation (6-1) can then be

itemized as

21 Brigham, Ehrhardt (2011, pp. 478-482).


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Additional financing needed = g OpA0 - g OpL0 - S0 (1 + g) m (1 - p) (6-2)

The resulting value needs to be assigned to particular sources of new financing, which

may include new short-term debt, long-term debt or equity, or any combination thereof.

This allows the construction of a pro-forma balance-sheet year by year over the whole planning

horizon. Using liquidity and leverage ratio analysis, adjustments to the plan are made as needed.

In principle, it is possible to adjust the financing structure decisions, the dividend payout ratio,

or the growth rate in sales to meet stipulated benchmarks.

Under circumstances, the method can be adjusted to allow for particular situations.

• Provided the firm has non-operating assets and liabilities, these would normally be

forecast at their current values (unless changes are made as part of management

decisions).

• Provided that non-current assets are not operating at full capacity, they need not

change until full capacity is reached.

• The dividend payout ratio may change, provided it is commensurate with the firm's

distribution policy

It should be noted that the growth rate in sales as well as the additional financing needed may

have negative values, which would imply a financing contraction. It is also possible to calculate

the self-supporting growth rate, which is the value of g in Equation (6-2) implying exactly zero

additional financing needed (in other words, it constitutes a break-even point); this may be of use

for firms that have limited access to external financing, or when such a reliance would be

considered too risky.

In contrast to the percent of sales method, the forecasted financial statement method

needs to simultaneously develop both pro-forma balance sheets and income statements. Usually,

its inputs include sales as well as other operating forecasts, such as in Figure 6.1. This makes

such a model much more realistic, but also difficult to handle. Besides, there needs to

be a resolution of feedbacks between the statements; for example, any adjustment of debt in the

balance sheet impacts interest expense, which in turn affects net income that may be retained,

but that would again require a recalculation of needed debt. It therefore becomes necessary to

use spreadsheet-based designs or automated forecasting modules of management information

systems (MIS) to prepare full forecasted statements.


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•

7. BUSINESS FINANCING

As we know already, one key function of financial management that normally arises

in the process of financial planning regards strategic decisions on business financing. Taking

such decisions influences business profitability, but also business risk.

Generally, firms' financing involves several sources. Short-term financing will be addressed

in more detail in Chapter 8. It uses instruments with a maturity shorter than one year,

but depending on the firm's working capital financing policies, some portions thereof may end up

being used for quite long periods, i.e. effectively as part of its capital. Long-term financing is

summarily called capital and will be addressed in this Chapter, which will first focus on the

possible sources of capital and financing instruments, and then on actual capital structure

decisions, their impacts, and the assessment of opportunity costs of capital for capital budgeting

decisions.

7.1 SOURCES OF CAPITAL

In order to exist, any firm needs equity, which represents the risk capital provided

by the owners, and forms the backbone of its financial structure22. For firms that are organized

as companies (the exact designation varies in different countries), equity takes the form

of ordinary shares of stock. There is no fixed rate of dividend and ordinary shareholders will

receive a dividend only if there is a net income available for distribution after all other investors,

such as creditors and preferred stockholders, have received their due. Similarly, they will receive

any proceeds from asset disposals if the business is wound up only after all other investors have

received their entitlements. Because of the high risks associated with ordinary shares, investors

will normally expect a relatively high rate of return.

However, there are two specific features, which may attract shareholders. One limits the

potential losses to the amount invested or committed to invest (this legal arrangement is called

22 Tirole (2006, pp. 75-102).


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limited liability), the other is the unlimited upside of potential returns. Ordinary shareholders also

control the business through their woting rights, which gives them the power to elect the directors

and to remove from office (the exact mechanism of exercising shareholder control also varies

under different legal environments).

From the firms' perspective, equity is attractive mainly because - in contrast to interest

and principal payments on debt - dividends are discretionary and firms can avoid paying them

when they lack the means to do so. Only when equity is completely depleted, would the firm be

obliged to file for bankruptcy. On the other hand, the opportunity cost of equity is higher than

that of debt, due to its higher risk for investors.

Firms obtain their equity from two sources: One is paid-in equity, provided by investors

at inception and - possibly - later in the life of the company when it needs to fund its further

growth. When the shares are distributed to the public, this typically entails significant one-time

flotation costs, which puts up the cost of equity, and thus motivates firms to use this form of

raising capital only when having a strong business case. Alternatively - and much more routinely

- firms supplement their equity with retained earnings, still bearing the opportunity cost, but

avoiding the transaction costs.

Beside ordinary shares (or common stock), some firms use preferred stock. These are

shares that normally pay a fixed dividend (making them similar to debt), but usually never repay

principal and firms may safely withhold dividends, provided common stockholders are not paid

either (making them similar to equity). Combining various features of financing instruments,

preferred stock is just one - admittedly most widely used - of the hybrid financing class, which

includes more exotic instuments such as convertibles and warrants.

Beyond equity, the second basic category of capital is long-term debt. Lenders enter into

a contract with firms, which states the interest rate, dates of interest payments, principal

repayments and - where relevant - additional agreements increasing security for the lender,

such as colleteral and loan covenants, which are restrictions on the business that form part of the

loan contract. For example, covenants may impose the right of lenders to receive regular

financial reports, an obligation to insure assets or not to sell certain assets, a restriction on further

borrowing, or a commitment to not exceed particular financial ratios. Assets pledged as collateral

may be seized and sold by the lenders in the event of default.


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Debt that is directly associated with a particular asset or set of assets belongs to

the category of asset-based finance23. Characteristically, it is then sufficient for lenders to focus

primarily on the revenue-generation capacity or liquidation value of such assets separately from a

full analysis of the firm. In some cases, loans are then granted without recourse to any other

obligations of the borrowing entity, assuming the respective assets' effective legal separation.

There are many distinct types of asset-based financing, including lease financing, which is most

common, as well as project financing, forfaiting, mortgage financing, commercial real estate

financing and loan securitization.

It is possible to issue loan capital that is subordinated to another class of loan capital on

the books. In such a case, holders of subordinated loan capital will not receive interest or

principal repayment until the claims of lenders ranked above them are met (such commitments

are called junior and senior, respectively).

Long-term debt can be provided directly by banks or other lenders, or it can be floated in

the capital market, taking the form of bonds. Generally, the opportunity cost of taking debt is

lower than that of using equity, because of the lower risk perceived by investors. Additionally, the

cost of debt decreases due to the fact that interest expenses - in contrast to dividends - are

deducted when determining the firm's earnings before taxes, which reduces after-tax cost. In

other words, taking debt creates a tax shield up to the maximum amount of taxes due by the

company from operations24.

23 Emery, Finnerty, Stowe (2007, pp. 608-633).

24 Some tax authorities constrain the tax shields firms may effectively use, using thin capitalization rules. In particular, these are aimed at loans extended between affiliated firms.


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7.2 CAPITAL STRUCTURE AND ITS COST

In the rudimentary case that a firm's capital consists of just two components, debt D and

equity E (each term stipulates their market values), with a debt ratio L = D / (D + E), its cost can

be determined as the weighted average of the component costs Dc and Ec, called the weighted

average cost of capital (WACC):

WACC = L × Dc + (1 - L) × Ec (7-1)

Provided the weighted average cost of capital uses realistic component costs, it can be

considered a fair estimate of the firm's opportunity cost of capital and thus used as the discount

rate for the assessment of its capital budgeting projects (by discounting estimated project cash

flows) or for the firm's valuation (by discounting forecasted free cash flows).

There are various ways of estimating the component costs of capital, but it has to be stressed

that opportunity costs always have to be applied. If, for example, the firm has taken a long-term

loan several years ago with 7% interest, its opportunity cost will not be 7%, but the rate at which it

would be borrowing now that might be substantially higher or lower. Similarly, there is an

opportunity cost to using equity even though there is no obligation to pay dividends, because the

capital could be used to earn a return if used otherwise.

• The cost of debt can be estimated from the yield on the debt of the firm, or a firm with a

similar risk profile (rating). This is easiest to determine for companies that have bonds

traded in the capital market, where an existing bond price allows calculation of the bond's

yield to maturity. Alternatively, other firms' bonds with comparable rating can be used, and

when no such instrument is available, it is possible to survey banks for their current loan

quotations.

• When deriving costs of debt from market-determined yields Dr, it is important to consider

the tax shield, which reduces the cost of debt Dc from the perspective of the borrower or

bond issuer. Designating the applicable marginal tax rate τ, this gives the relationship Dc =

(1 - τ) Dr, which can than be instated in Equation (7-1).

• The cost of equity estimate is often based on the capital asset pricing model (CAPM),

which introduces a measure of market risk sensitivity β to derive a simple linear

relationship between the risk of stock and its expected return as Er = Fr + β (Mr - Fr), where

Fr constitutes the risk-free rate and Mr the expected return of the stock market as a whole. It


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must be noted that raising new equity externally - in contrast to earnings' retention -

typically involves substantial flotation costs, which increases the cost of equity Ec above

the investors'

yield Er.

For example, a firm may have a target debt ratio L = 40% and face a marginal tax rate τ =

20%. It has a traded bond in the market, whose yield to maturity is Dr = 5%, the yield to maturity

of a treasury bond (i.e. the market's trisk-free rate) is Fr = 2%, the company stock's β = 1.2 and

the expected average return of the stock market is Mr = 7%. The stock's expected return will then

be Er = 2% + 1.2 (7% - 2%) = 8%, and its opportunity cost of capital WACC = 40% × (1 - 20%) ×

5% + (1 - 40%) × 8% = 6.4%.

While firms have a number of different opportunities to source capital, the primary problem

they need to resolve relates to the optimal debt-equity composition of capital. In other words, they

need to determine their target debt ratio L.

Similarly to other issues in finance, such a decision entails a trade-off between risk and

expected return. On the one hand, increasing leverage intensifies the firm's use of the tax

shield, even without considering the lower opportunity cost due to debt being less risky than

equity. On the other hand, any increase in debt increases the likelyhood of bankruptcy in the

case of adverse business developments which might result in capital depletion.

In theory, optimal capital structure for any particular company can be derived by combining

the impacts of several factors:

• Increasing debt increases the return on equity, provided the return on assets remains

unchanged.

• Increasing debt reduces the taxes paid by the company, because interest expenses

are deductible when calculating taxable income.

• Increasing debt increases the opportunity cost of equity, because the fixed claim of

debtholders causes the residual claim of stockholders to become riskier.

• Increasing debt increases the cost of debt, because it raises the probability of financial

distress, and thus the default risk on the debt.

• Very high levels of debt, which suggest a substantial risk of bankruptcy, may also lead to

the reduction of free cash flow due to the loss of some customers, i.e. sales, and


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potentially also production efficiency (tighter credit standards by suppliers, loss of key

employees).

The first two factors encourage firms to take on debt, the remaining ones make additional debt

progressively expensive. In the aggregate, this leads to a point where the costs outweight the

benefits of leverage, which should determine the firm's optimal capital structure.

In addition, asymmetric information between shareholders and managers leads to

shareholders perceiving capital-related decision, such as the forms of raising new capital, or

dividend distributions, as signals, which in turn impact the stock price.

Suppose, for example, that the firm knows of a highly profitable business opportunity requiring

a substantial capital investment. Its current shareholders would then have a strong incentive to

raise new debt, rather than equity, because they would not have to share the profits with new

investors. On the other hand, knowledge of potential issues that might reduce future earnings

encourages dilution through issuing new equity. Accordingly, the announcement of a stock

offering is often taken as a signal that the firm's prospects as seen by its own managers are not

good; conversely, a debt offering is taken as a positive signal.

While useful for a broader understanding of these factors and their impacts, it is unrealistic to

assume that most firms would actually use a quantitative economic model to optimize their capital

structure25. In practice, they usually combine quite simple rules:

• Firms benchmark their target capital structure to be in line with that of comparable

successful firms. This means that there tends to be a characteristic capital structure for

firms operating in the same market, in the same industry, with a similar structure of assets,

with similar business opportunities, and with a comparable ownership structure.

• Within bounds, firms raise the capital they need according to a pecking order, considering

the existence of flotation costs and asymmetric information. Broadly speaking, they first

raise capital internally by reinvesting net income and selling short-term marketable

securities. When that supply of funds has been exhausted, they will issue debt, and only as

a last resort will they issue common stock.

25 For a more detailed explanation of the theoretical concepts of capital structure, as well as empirical evidence on firm's actual approaches, see Baker, Martin (2011).


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• In order to mitigate the signaling problem, many publicly traded companies try to maintain a

reserve borrowing capacity, i.e. use more equity in normal times than is suggested by

the risk-cost trade-off or pecking order, so that debt can be used if an especially good

investment opportunity comes along.


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8. WORKING CAPITAL MANAGEMENT

Working capital is the part of a firm's capital that is short-term in nature, in other words, current,

and is used in its day-to-day operations. It therefore relates to the firm's operations management.

The main elements of working capital thus include:

Operating current assets

• Cash (usually in part)

• Inventory

• Trade receivables

Operating current liabilities

• Trade payables

• Accruals

The amount invested in working capital at any point of time can then be assessed in the balance

sheet by subtracting the current assets and current liabilities, i.e.

Working capital = Operating current assets - Operating current liabilities (8-1)

Besides operating current assets and operating current liabilities, firms may own some

non-operating current assets or liabilities, such as marketable securities held in reserve, which

would not be used in the day-to-day operations of the company, and thus considered part

of working capital. Bank overdrafts and short term loans are also not considered operating, while

judgement needs to be employed to determine what part of cash (including current account

balances) is directly involved in operations.

The size and composition of working capital varies between different industries, and the

investment can be substantial. A manufacturing business, for example, will often invest heavily in

raw material, work in progress and finished goods. It will also normally sell its goods on credit,

giving rise to trade receivables. A retailer, meanwhile, holds only one form of inventory, finished

goods, which have been furthermore purchased on credit, and will sell the goods for cash rather

than on credit. Many service businesses hold virtually no inventory.


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8.1 CASH CONVERSION CYCLE

Working capital represents a net investment in short-term operating assets. These assets

are continually flowing in and out of the business and are essential for day-to-day operations.

The various elements of working capital are interrelated and can be perceived as part of a cycle

illustrated by Figure 16.1., which is commonly called the cash conversion cycle, or working

capital cycle.

Figure 31. Cash conversion cycle

Source: Vlachý (2018, p. 139)

Accordingly, cash is used to pay trade payables due on some date after the delivery of

materials, which then become inventory in different stages of production until finished goods are

sold on credit, resulting in a delay before cash is received from the sales. Receipt of cash

completes the cycle.

It is possible to quantify the cash conversion cycle in terms of the average investment

time (in days) for the main working capital elements and, based on those figures, calculate the

total time needed to finance the cash conversion cycle. Typically, average investment time is

estimated from the firm's financial statements, using the following ratios26:

Average collection period = Average trade receivables / Sales per day (8-2)

26 The ratios are often called simply average days receivable, average days payable, and average days in inventory.

Selling goods

Inventory conversion period Average collection period

Payables defeeral period Cash conversion period

Receiving materials Collecting cash

Paying for materials


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Payables deferral period = Average payables / CGS + SGA per day (8-3)

Inventory conversion period = Average inventory / CGS per day (8-4)

The average balance sheet items (receivables, payables, inventory) are normally

determined as the average of beginning- and end-of-period values, daily costs and revenues as

periodical totals divided by the number of days in the period. Accordingly, if a firm had sales of

€150 million in the last quarter, with €50 million receivables in its beginning and €60 million in its

end, its average collection period can be calculated as [(50+60) / 2] ÷ [150 / 90] = 33 days.

The management of working capital is an essential part of the firm's short-term planning

process, but the structure of the cash conversion cycle can also be influenced by particular

investments, such as in monitoring systems or inventory management infrastructure.

8.2 MANAGING TRADE RECEIVABLES

Selling goods or services on credit will result in costs incurred by the firm. These include

the costs of credit administration, of bad debts, and financing costs. These must be weighted

against the benefits of increased sales revenue from customers obtaining the incentive of

delayed payment. In fact, outside the retail business, selling on credit is the norm.

When a firm offers to sell on credit, however, it needs to have clear policies regarding:

• Which customers should receive credit

• How much credit should be offered

• What credit terms should be offered; these involve the length of credit and, possibly,

whether discounts will be offered for prompt payment

• What collection and risk-mitigation policies should be adopted

The first two policies relate primarily to the customer's credit standing, which is influenced by

a number of factors, financial as well as non-financial in nature. These may be assessed using

various sources of information, including trade or bank references, published financial

statements, credit agencies, or mutual relationship history.


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The length of credit depends primarily on custom within the industry, competition

and bargaining power, credit capacity, and marketing strategy. To encourage prompt payment,

a business may offer cash discounts.

The risk of non-payment is also mitigated by efficient collection policies, which include

customer relationship management, prompt issuance of invoices, receivable monitoring

and appropriate follow-up action. It can also be reduced by measures such as advance payment,

netting, third-party guarantees or insurance.

8.3 CASH MANAGEMENT AND WORKING CAPITAL FINANCING

The day-to day management of cash is planned and controlled by means of the cash

budget27. Most firms hold some amount of cash. Broadly speaking, there are three reasons why

they do so:

• To meet day-to-day commitments. Generally, any payments should be paid when they

fall due, which requires cash; failure to meet current commitments may jeopardize the

firm's survival. Strictly speaking, this is the only part of cash balances that should be

considered working capital.

• As a precaution. Whenever any future cash inflows or outflows are uncertain (and they

always are, to some degree), it is prudent to hold cash in reserve.

• To exploit opportunities. Holding cash facilitates making use of bargain opportunities,

such as purchasing supplies at a discount or acquiring the business of a competitor in

financial distress.

The amount of cash needed for business varies significantly, depending particularly on:

• The nature of the business, including its seasonality;

• Opportunity costs of holding cash and availability of contingency borrowing or selling

liquid assets;

• Economic conditions, including inflation;

27 See also Chapter 6.


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• Relationships with suppliers providing trade credit, which may be stretched as a means

of obtaining cash.

These and other factors, including the degree of risk aversion by managers and shareholders,

determine the particular policies that firms use for their cash management and working capital

financing needs. Each impacts risk as well as profitability.

One policy decision relates to current asset holdings. Besides inventory and accounts

receivable, which are determined by separate policies, these include cash and marketable

securities held as substitute for cash. Possible policies range from relaxed to restrictive,

with a moderate policy lying between the two extremes. A relaxed policy means a high level of

assets and hence a low asset turnover ratio, resulting in a low return on equity, other things held

constant28.Conversely, a restrictive policy result in low current assets, a high turnover, and hence

a relatively high ROE.

It is to be noted that there are possibilities to decrease the net cost of holding current assets

without increasing the risk of cash shortage. These cash management techniques include:

• Holding marketable securities in lieu of cash. This generates some yield as a non-

operating investment, even if usually much lower than operating assets.

• Arranging formal or informal credit lines with banks. Even though this often entails

commitment fees, they are normally lower than the opportunity cost of holding cash.

• Taking steps to reduce float, for example by using electronic payments systems,

improving payments monitoring, and netting liabilities.

• Reducing the need for transaction balances on separate accounts by cutting down the

number of accounts used, or by cash pooling.

The asset holding policy combines with the working capital financing policy. This

determines what part of working capital should be financed short-term, and what should be

financed long-term. One factor to be considered is the firm's particular break-up of working

capital needs between those that are seasonal or cyclical, and those that are essentially

28 Formally, this pattern appears from the Du Pont equation stipulating that ROE = Profit margin × Total asset turnover × Equity multiplier = Net income / Sales × Sales / Total assets × Total assets / Equity (Brigham, Ehrhardt, 2011, pp: 106-107).


140

permanent even at the low point of the cycle. Managers may then choose between several

approaches, illustrated in Figure 8.2.:

• Aggressive approach. This finances all temporary current assets and a substantial part of

permanent current assets short-term, aiming at a cost reduction due to the usually lower

cost of short-term financing, compared to long-term, while accepting the risk of a sudden

rate increase or liquidity squeeze.

• Conservative approach. In contrast to the aggressive approach, this minimizes risk by

financing all permanent current assets, as well as a part of the seasonal assets long-term.

Any temporary cash surpluses would be used to purchase low-risk marketable securities

and only a small amount of seasonal needs would be financed by overdraft.

• In practice, most firms ultimately prefer some compromise between these extremes. A

popular one uses some form of maturity matching (called also self-liquidating) approach,

which calls for matching asset and liability maturities. All of the fixed assets plus the

permanent current assets are financed with long-term capital, but temporary current assets

are financed with short-term debt. Strictly speaking, this should mean that inventory

expected to be sold in 30 days would be financed with a 30-day bank loan, while a building

expected to last for 15 years would be financed with a 15-year mortgage bond.


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Figure 32. Working capital financing policies

Source: Brigham, Ehrhardt (2011, p. 641)

To the extent needed, short-term financing of working capital can relate to particular

assets, or may constitute a general liability of the firm.

• Trade receivables can be turned into cash by either factoring them, or having sales

invoices or bills of exchange29 discounted, all of which are forms of short-term asset-based

finance. When negotiated on a non-recourse basis, these methods also transfer the risk of

non-payment. A simpler, less formal way of using receivables as security pledges accounts

receivable.

• Inventory may also be used as security for short-term debt, using methods such as trust

receipts or warehouse financing.

On an unsecured basis, firms may use

29 Nowadays, bills of exchange are used mainly in the domain of international trade.

b) Aggressive policy

time

Temporary current assets

Permanent current assets

Fixed assets

L-T financing

time



Fixed assets

L-T financing

time



Fixed assets

L-T financing

S-T financing S-T financing

a) Conservative policy c) Maturity matching


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• Bank overdrafts, which enable a business to maintain a negative balance on their bank

accounts. It is very flexible and typically easy to arrange, but usually limited in amount. It is

also repayable on demand, and may therefore constitute liquidity risk for the firm

• Short-term bank loans, providing more financing security, but less flexibility than

overdrafts.

• Commercial paper, which is a debt security placed in the market. This is restricted to a

comparatively small number of large companies that offer very good credit risk, but then

often gives the borrowing firms very competitive terms.


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9. INVENTORY MANAGEMENT

A firm may hold inventory for various reasons, the most common of which is to meet

the immediate day-to-day requirements of customers and production. However, it also often

holds more than is strictly necessary for this purpose in order to mitigate risks. The risk may

relate to the possibility that future supplies will be interrupted or scarce, or that their cost will

increase. Businesses that mine or trade commodities often try to benefit from holding large

quantities when prices are expected to rise, while production firms mostly consider the potential

costs of disruption. Broadly speaking, the reasons are quite similar to the rationale of holding

cash.

For some types of business, inventory represent a substantial proportion of their total assets.

For instance, a car dealership that rents its premises may have nearly all of its total assets in the

form of inventory. Manufacturers also tend to invest heavily in inventory as they need to hold

three types: raw materials, work in progress and finished goods, each representing

a particular stage in the production cycle. Furthermore, for firms with seasonal demand, the

level of inventory may vary substantially over the year.

Firms that hold inventory primarily to meet the day-to-day requirements of production, as well

as their customers, will normally seek to minimize the total amount of inventory. This is because

there are significant costs associated with holding inventory, including:

• Storage and handling costs;

• The cost of financing inventory, including opportunity costs;

• The costs of damages and obsolence.

Note that savings in the cost of financing due to minimizing inventory would be taken

into account while assessing the corresponding impact of shortening the cash conversion cycle,

but the remaining two items relate specifically to inventory management.

Given the potentially high cost of holding inventory, it may be tempting to believe that the firm

should aggressively minimize inventory, perhaps even keeping its level close to zero. However,

there are also costs that arise when the level of inventory is too low. Under circumstances,

these may include:


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• Loss of sales or customer goodwill. This is due to being unable to provide required goods

immediately.

• Higher purchasing or transport cost. This is due to buying or transporting at a higher

price in order to replenish inventory quickly.

• Forfeited production capacity or inefficient production. This is due to shortage of raw

materials or other supplies.

To help manage inventory, a number of procedures and techniques have been developed,

some of which will be introduced in the following paragraphs. They can be broadly divided into

inventory control systems and inventory forecasting models, even though in practical usage the

methods frequently combine and overlap.

9.1 MONITORING AND ORDERING SYSTEMS

A well-organized system of recording inventory movements is a key element in managing

inventory. This involves proper procedures for monitoring inventory purchases, delivery,

movements between storage areas and warehouses, as well as usages. Periodic checks have to

be made to ensure that the amount of physical stock corresponds with what is indicated by the

inventories' records. There also need to be clear procedures for inventory reordering, whose

determination includes the assessment of lead time, i.e. the time between the placing of an order

and the receipt of the goods, and the likely level of demand. Carrying additional stock in reserve

will increase the cost of holding inventory. This must, however, be weighted against the cost of

running out of inventory, in terms of lost sales, production problems and so on.

Adopting any particular level of inventory control requires a careful consideration of costs

and benefits. This may lead to the implementation of different control levels according to the

nature of inventory. The ABC system is thus based on the idea of selective control levels,

recognizing that some items are more important than others and it makes good sense to direct

costly management effort to those items. It classifies the most important items as type "A", where

the most frequent and precise periodical reviews and forecasts would be applied, while the less

important items fall in the "B" category, and the even less important inventory items are

designated "C".


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The red line method is probably the simplest inventory control technique imaginable.

It would nowadays be used by relatively small unsophisticated firms, or for "C" items under the

ABC system, such as those used by cleaning or maintenance service not critical for operations.

The method actually originated with stockkeepers making a red line in a container or rack, which

indicated the reorder point, i.e. the level of inventory at which the item should be reordered.

Its use is quite limited; for example, it will only work for items that are all stored in one place,

and the proper positioning of the reorder point (red line) requires a good deal of experience.

Various kinds of computerized inventory control systems are becoming more

and more common, benefitting from the broad availability of the necessary hardware

and software. They can keep track of the stocks of all items at any location and at all times,

and signal when reorder points have been reached. They use different components, such as

point-of-sale (POS) systems, common in retailing where cashiers key or scan every purchase

into the cash register, standardized bar-code systems that can be applied in the whole supply

chain, or radio-frequency identification (RFID) systems, allowing a real-time automated

tracking of each individual inventory item wherever it may be located.

Complex manufacturing systems in highly competitive industries, such as automotive,

require sophisticated coordination and scheduling of deliveries and further processing of large

numbers of components from multiple suppliers. Such firm typically rely on computer-based

materials requirement planning (MRP) systems, planning backward from the production

schedule to make purchases and manage inventory, combining information about the production

and the supply processes.

Somewhat related is the concept of just-in-time systems, based on the idea

that materials should arrive exactly as they are needed in the production process. While attractive

due to its potential to greatly reduce inventory stock, the method relies on several factors,

including very sophisticated coordination and planning, as well as tight control and outstanding

supplier relationships, which make it practicable only under specific circumstances.


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9.2 FORMAL INVENTORY MODELS

One of the best ways to ensure that inventory will be available to meet future production

and sales needs involves preparing realistic forecasts. These may be developed in various

ways including the use of statistical techniques30, as well as reliance on the opinions of sales and

marketing staff.

A formal statistical model widely used by practitioners is the economic order quantity

(EOQ) model. It relies on several simplifying assumptions, which result in a conveniently simple

solution:

The main assumption is that inventory usage occurs at a constant rate. This means

that, in time, the stock will follow the pattern shown in Figure 9.1.

Figure 33. Inventory pattern for the EOQ model

Source: Anderson, Sweeney, Williams (2016, p. 461), modified

If the starting level of inventory is Q (as quantity), it will fall at a constant rate from this

initial point, until it is fully depleted and needs to be replenished to its starting level. It can be

easily seen that the average amount of inventory in stock will be Q / 2 units.

30 A more detailed description of inventory models, including their derivations, is provided by Anderson, Sweeney and Williams (2016, pp. 457-505).

Time

Inventory

Q

Q/2

Average inventory

Q/S


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The goal of solving the EOQ model is to choose the inventory ordering amount,

and the order frequency, that gives the lowest total costs of maintaining the inventory.

These depend on two separate factors, the ordering cost and the carrying cost, defined as

follows:

• The ordering cost (F) is the fixed cost of placing and delivering an order, unrelated to the

size of the order. It includes the cost of paperwork and communication with the supplier,

but also any fixed costs passed on to the customer, including handling and - possibly -

shipping.

• The annual carrying cost (C) is the variable cost per unit related to the amount of stock

in inventory, including storage costs, as well as the opportunity cost of financing the stock.

Designating S the annual sales (or usage, if the inventory is used internally) in unit terms

and P the purchase price per unit, the total annual cost of inventory (TC) can be expressed as

the sum of total annual carrying cost and the total annual ordering cost, i.e.

TC = Q / 2 × C + S / Q × F (9-1)

Using calculus, it is easy to derive the optimal order size Q* minimizing the value of TC,

which is then called the economic order quantity (EOQ), and given by

EOQ = Q* = √2𝐹𝑆

𝐶 (9-2)

Once the optimal order size is known, it can be used to determine the corresponding

order frequency as S / Q*.

For example, a storage room may dispatch items of stock at a constant rate of S =

20,000 units per year with a F = € 200 cost of executing one order and a C = € 50 cost of carrying

a unit in inventory per year. Using Equation (9-2), we determine that the economic order quantity

is 400 units. The order frequency should be 20,000 / 400 = 50 times per year (i.e. approximately

every week) and the total cost is 400 / 2 × 50 + 20,000 / 50 × 200 = € 20,000.


148

Besides constant inventory usage (which, for instance, precludes seasonality), the EOQ

model assumes instantaneous inventory replenishment (i.e. no lead times, which is usually

unattainable) and full certainty in future demand. A firm can protect itself from either by

maintaining safety stocks.

There are two ways in which these factors may be taken into account in a refined EOQ

model. First, it is possible to simply put the reorder point back in time by the expected lead time,

plus the time needed to maintain the minimum safety stock. Second, the firm can estimate the

expected cost of stockout (i.e. the expected annualized cost of the firm running out of stock,

determined as the probability of a stockout times the cost of a stockout), instating it as the third

component of the total annual cost in Equation (9-1) before optimizing the order quantity.

More sophisticated inventory models assume probabilistic demand. While being much

more realistic and universal than variants of the EOQ model (for instance, it is quite simple to

include factors such as seasonality), they are much more demanding in terms of using statistical

techniques, including the estimation of particular statistical distributions' parameters. Besides the

basic uncertainty in demand, they may consider other kinds of uncertainty, such as that in actual

lead time. The possible approaches to solving such models include stochastical calculus, as well

as computer-based Monte Carlo simulations.


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10. PRICING AND COSTING

A vital ingredient of business economics is pricing. Pricing decisions are based on several

considerations involving primarily the characteristic of demand. An essential counterpart

to pricing is the process of allocating costs to particular products. Combining the two allows

firms to take vital business decisions on the product level, such as whether it should commence

or terminate its production. This is a separate, but complementary view to capital budgeting,

and thus needs to be part of the managers' perspective.

Generally speaking, economics searches for the profit-maximizing price and output for the

good or service a business sells. Its profit from any decision is the difference between predicted

revenues and costs. Increasing output and sales will increase profit, as long as the extra revenue

exceeds the extra cost incurred. Conversely, the firm will profit by cutting output if the cost saved

exceeds the revenue given up. Accordingly, if economic conditions change, the firm's optimal

price and output will change according to the impact on its marginal revenues and marginal

costs, i.e. the additional revenue gained and additional cost incurred on an incremental unit of

production31.

Marginal profit is the difference between marginal revenues and marginal costs,

and it is easy to show that the firm should commence or continue production for as long as there

is a positive marginal profit, i.e. marginal revenues exceed marginal costs. When this ceases to

be the case, production should be terminated. This is clearly illustrated by Figure 18.1., which

matches the maximum of the total profit function with the break-even point of the marginal profit

function.

.


150

Figure 34. Total profit and marginal profit

Source: Samuelson, Marks (2016, p. 32)

-150

-100

-50

0

50

100

150

0 1 2 3 4 5 6 Quantity

Total profit

-150

-100

-50

0

50

100

150

0 1 2 3 4 5 6 Quantity

Marginal profit


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10.1 DETERMINANTS OF DEMAND

The basic economic formulation simply derives demand (in terms of quantity) from a one

or more factors, usually including the price, in the form of a demand function. There are several

ways in which demand can be estimated and forecasted.

Data can be collected using

• Consumer surveys. Asking potential customers about their plans and preferences, face to

face, by telephone, online, etc. When executed properly they are useful in providing

structured answers, but have substantial limitations due to biases and response accuracy.

• Controlled market studies. They allow observations of the market in a structured manner,

usually by selling the same product in several test markets while varying key demand

determinants. The analyses may then be cross-sectional (with different parameters

in different markets at the same time) or based on time series (varying the decision

variables over time in the same market).

• Uncontrolled market studies. Using data mining techniques, the vast amounts

of information available in propriatory databases or online are collected to track and

analyze consumer behaviour patterns.

The data is then usually processed and interpreted using regression analysis, a set of

statistical techniques using past observations that best summarizes the relationships among key

economic variables, such as the demand function. Forecasting uses either structural models

which identify how variables depend on each other, or nonstructural models which look at

patterns over time.

Aside from exact quantitative methods that aim at determination of the demand curve,

managers should be aware of more general demand determinants, facilitating qualitative

judgement. Of these, the following ones are usually the most important:


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• Clearly, the good's own price is a key determinant of demand. The sensitivity of sales to

changes in the good's price is called price elasticity. Demand can thus be elastic or

inelastic, which impacts optimal pricing decisions.

• Close behind is the level of income of the potential buyer of the good or service. A

product is called a normal good if an increase in income raises its sales. However, for a

small category of goods, called inferior goods, an increase in income causes a reduction in

spending.

• A third set of factors affecting demand are the prices of substitute goods, which compete

with and can substitute for the good in question, and the prices of complementary

goods, wherean increase in demand for the one causes an increase of demand for the

other.

One common business practice that lets companies benefit from diverse consumer demand

determinants is price discrimination. This occurs when a firm sells the same good or service to

different buyers at different prices. Two conditions need to be met for price discrimination to be

effective.

• The firm must be able to identify market segments that differ with respect to price

elasticity of demand, because it profits by charging a higher price to the more inelastic

market segment.

• It must be capable to enforce the different prices paid by the different segments, which

means that the payers of higher prices must be unable to take advantage of the lower

prices.

10.2 PRODUCT COSTING

In order to properly assess their product-related business decisions, firms need to be

aware of the cost structure of their individual products and services. For the purpose

of allocating costs, on the most general level, these are normally classified as either direct

or indirect. Direct costs can be easily traced to a specific cost object, such as a product, indirect

costs cannot. Indirect costs include common costs, which are incurred to support a number

of cost objects, but cannot be traced to them individually.

Another cost classification characterizes cost behaviour. Total variable cost varies

in direct proportion to changes in the level of activity (this may be, for example, units produced,


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units sold, direct labour-hours or machine-hours). In contrast, a fixed cost remains constant,

regardless of changes in the level of activity. Finally, semivariable costs contain both variable

and fixed cost elements

Based on particular business characteristics, the methods used to obtain the necessary

information, which is usually integrated in managerial accounting, may differ quite substantially.

For example, most manufacturing companies separate their manufacturing costs into two direct

cost categories, direct materials and direct labour, and one indirect cost category, manufacturing

overhead. Nonmanufacturing costs are then often divided into selling costs, which can be either

direct or indirect, and common administrative costs.

Several different methods are used to allocate costs to products32:

Job-order costing is used in situations where many different products, each with

individual and unique features, are produced in any given period. This may relate to custom

manufacturing or repair shops, large-scale construction projects, as well as service industries

including law firms, accountants, hospitals, advertising agencies and movie studios. Under this

system, materials and labour are immediately charged to the particular job using job cost sheets,

manufacturing overhead is allocated to products using a pre-determined and common allocation

base, such as direct labour-hours, direct labour cost or machine-hours.

Job-order costing is a common method using absorption costing, in which all

manufacturing costs are assigned to units of products, while all nonmanufacturing costs are

treated as period costs. An alternative approach, called activity-based absorption costing,

assigns all manufacturing overhead costs to products based on the activities performed to make

those products. First, costs are accumulated in activity cost pools, which are only then assigned

to products.

In contrast to job-order costing, process costing is used when firms produce a

continuous flow of units that are indistiguishable from one another. It is still an absorption costing

method, but accumulates costs by department, assigning them uniformly to all identical units that

pass through the department during a period.

32 Garrisson, Noreen, Brewer (2018, pp. 67-109, 154-195, 310-361).


154

Activity-based costing (ABC) broadens the allocation base above that of absorption

costing methods to include directly attributable nonmanufacturing costs, but retains

manufacturing overhead costs as period costs. It uses activity cost pools as buckets for the

accumulation of costs relating to an activity measure, such as the number of transactions or an

activity's duration. Besides unit-level, activities can be defined as batch-level, product-level or

customer-level, for example, allowing for the setting up of highly customized costing systems.


155

References for PART B

- Anderson, D.R., Sweeney, D.J., Williams, T.A. et al. An Introduction to Management Science:

Quantitative Approaches to Decision Making. 14th Ed. Mason (OH): Cengage, 2016.

- Baker, H.K., Martin, G.S. Capital Structure and Corporate Financing Decisions: Theory,

Evidence and Practice. Hoboken (NJ): John Wiley, 2011.

- Brigham, E.F., Ehrhardt, M.C. Financial Management: Theory and Practice. 13th Ed. Mason

(OH): Cengage, 2011.

- Capiński, M., Zastawniak, T. Mathematics for Finance: An Introduction to Financial

Engineering. London: Springer, 2003.

- Damodaran, A. Applied Corporate Finance. 4rd Ed. Hoboken (NJ): John Wiley, 2005.

- Emery, D.R., Finnerty, J.D., Stowe, J.D. Corporate Financial Management. 3rd Ed. Upper

Saddle River (NJ): Pearson, 2007.

- Garrison, R.H., Noreen, E.W., Brewer, P.C. Managerial Accounting. 16th Ed. New York (NY):

McGraw-Hill, 2018.

- Gordon, M.J., Shapiro, E. Capital Equipment Analysis: The Required Rate of Profit.

Management Science, 3(1): 101-110, 1956.

- Hartman, J.C., Schafrick, I.C. The Relevant Internal Rate of Return. The Engineering

Economist, 49(2): 139-158, 2004.

- Mun, J. Modeling Risk. Hoboken (NJ): John Wiley, 2006.

- Popatia, K. IFRS & GAAP: Reconiling Differences Between Accounting Systems and

Assessing the Proposed Changes to the IFRS Constitution. Northwestern Journal of

International Law & Business, 38(1): 137-159, 2017.

- Samuelson, W.F., Marks, S.G. Managerial Economics. 8th Ed. Hoboken (NJ): John Wiley,

2015.

- Tirole, J. The Theory of Corporate Finance. Princeton (NJ): Princeton University Press, 2006.

- Vlachý, J. Corporate Finance. Praha: Leges, 2018


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List of figures for PART B

Figure21. Balance sheet (as of December 31, € million) ............................................................... 95

Figure22. Income statement (for 2018, € million) .......................................................................... 96

Figure23. Asset depreciation ......................................................................................................... 97

Figure24. Statement of cash flows (for 2018, € million) ................................................................ 99

Figure25. Calculation and use of free cash flow (for 2018, € million).......................................... 101

Figure26. Cash flows of a 5-period annuity ................................................................................. 106

Figure27. Tornado diagram .......................................................................................................... 118

Figure28. Sensitivity graph ........................................................................................................... 119

Figure29. Interaction of financial planning decisions ................................................................... 123

Figure30. Monthly cash budget .................................................................................................... 125

Figure31. Cash conversion cycle ................................................................................................. 136

Figure32. Working capital financing policies ................................................................................ 141

Figure33. Inventory pattern for the EOQ model........................................................................... 146

Figure34. Total profit and marginal profit ..................................................................................... 150


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Kornélia Lazányi

has received her PhD in 2010 in management sciences. Being the researcher of business

management for over 20 years, she has dedicated her full attention to organisational processes

and organisational behaviour. She regards organisations as open, sociotechnical entities, where

the human factor is at least as important as other assets. Hence, the first part of the book introduces

theories and practices related to the management of people.

Jan Vlachý

has spent most of his professional career in various executive and advisory positions involving finance

and financial services. He also has twenty years of teaching experience, mainly in international

programmes, published four monographs and over thirty peer-revieved papers . His research interests

include corporate finance, financial markets and financial history. Readers are welcome to contact him

at [email protected].

Business Management for Logisticians

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