Foundations of business analysis

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Chapter 1 The Foundations of Business Why Is Apple Successful? 1 In 1976 Steve Jobs and Steve Wozniak created their first computer, the Apple I. They invested a mere 1,300 and set up business in Jobs’s garage. Three decades later, their business—Apple Inc.—has become one of the world’s most influential and successful companies. Did you ever wonder why Apple flourished while so many other young companies failed? How did it grow from a garage start-up to a company generating 65 billion in sales? How was it able to transform itself from a nearly bankrupt firm to a multinational corporation with locations all around the world? You might conclude that it was the company’s products, such as the Apple I and II, the Macintosh, or more recently its wildly popular iPod, iPhone, and iPad. Or you might decide that it was its people: its dedicated employees and loyal customers. Perhaps you will decide it was luck—Apple simply was in the right place at the right time. Or maybe you will attribute the company’s success to management’s willingness to take calculated risks. Perhaps you will attribute Apple’s initial accomplishments and reemergence to its cofounder, the late Steve Jobs. After all, Jobs was instrumental in the original design of the Apple I and, after being ousted from his position with the company, returned to save the firm from destruction and lead it onto its current path. Before we decide what made Apple what it is today and what will propel it into a successful future, let’s see if you have all the facts about the possible choices: its Saylor URL: 2 products, its customers, luck, willingness to take risks, or Steve Jobs. We’re confident that you’re aware of Apple’s products and understand that “Apple customers are a loyal bunch. Though they’re only a small percentage of all computer users, they make up for 2 it with their passion and outspokenness.” We believe you can understand the role that luck or risk taking could play in Apple’s success. But you might like to learn more about Steve Jobs, the company’s cofounder and former CEO, before arriving at your final decision. Growing up, Jobs had an interest in computers. He attended lectures at Hewlett- Packard after school and worked for the company during the summer months. He took a job at Atari after graduating from high school and saved his money to make a pilgrimage to India to search for spiritual enlightenment. Following his India trip, he attended Steve Wozniak’s “Homebrew Computer Club” meetings, where the idea for 3 building a personal computer surfaced. “Many colleagues describe Jobs as a brilliant man who could be a great motivator and positively charming. At the same time his drive for perfection was so strong that employees who did not meet his demands are faced 4 with blistering verbal attacks.” Not everyone at Apple appreciated Jobs’s brilliance and ability to motivate. Nor did they all go along with his willingness to do whatever it took to produce an innovative, attractive, high-quality product. So at age thirty, Jobs found himself ousted from Apple by John Sculley, whom Jobs himself had hired as president of the company several years earlier. It seems that Sculley wanted to cut costs and thought it would be easier to do so without Jobs around. Jobs sold 20 million of his stock and went on a two-month vacation to figure out what he would do for the rest of his life. His solution: start a new personal computer company called NextStep. In 1993, he was invited back to Apple (a good thing, because neither his new company nor Apple was doing well). Steve Jobs was definitely not humble, but he was a visionary and had a right to be proud of his accomplishments. Some have commented that “Apple’s most successful Saylor URL: 3 5 days have occurred with Steve Jobs at the helm.” Jobs did what many successful 6 CEOs and managers do: he learned, adjusted, and improvised. Perhaps the most important statement that can be made about him is this: he never gave up on the company that once turned its back on him. So now you have the facts. Here’s a multiple-choice question that you’ll likely get right: Apple’s success is due to (a) its products, (b) its customers, (c) luck, (d) willingness to take risks, (e) Steve Jobs, or (f) some combination of these options. 1 This vignette is based on an honors thesis written by Danielle M. Testa, “Apple, Inc.: An Analysis of the Firm’s Tumultuous History, in Conjunction with the Abounding Future” (Lehigh University), November 18, 2007. 2 Ellen Lee, “Faithful, sometimes fanatical Apple customers continue to push the boundaries of loyalty,” San Francisco Chronicle, March 26, 2006. 3 Lee Angelelli, “Steve Paul Jobs,” (accessed January 21, 2012). 4 Lee Angelelli, “Steve Paul Jobs,” (accessed January 21, 2012). 5 Cyrus Farivar, “Apple’s first 30 years; three decades of contributions to the computer industry,” Macworld, June 2006, 2. 6 Dan Barkin, “He made the iPod: How Steve Jobs of Apple created the new millennium’s signature invention,” Knight Ridder Tribune Business News, December 3, 2006, 1. 1.1 Introduction As the story of Apple suggests, today is an interesting time to study business. Advances in technology are bringing rapid changes in the ways we produce and deliver goods and services. The Internet and other improvements in communication (such as smartphones, video conferencing, and social networking) now affect the way we do business. Companies are expanding international operations, and the workforce is more diverse than ever. Corporations are being held responsible for the behavior of their executives, and more people share the opinion that companies should be good corporate citizens. Plus—and this is a big plus—businesses today are facing the lingering effects of what many economists believe is the worst financial crisis since the Saylor URL: 4 1 Great Depression. Economic turmoil that began in the housing and mortgage industries as a result of troubled subprime mortgages quickly spread to the rest of the economy. In 2008, credit markets froze up and banks stopped making loans. Lawmakers tried to get money flowing again by passing a 700 billion Wall Street bailout, yet businesses and individuals were still denied access to needed credit. Without money or credit, consumer confidence in the economy dropped and consumers cut back their spending. Businesses responded by producing fewer products, and their sales and profits dropped. Unemployment rose as troubled companies shed the most 2 jobs in five years, and 760,000 Americans marched to the unemployment lines. The stock market reacted to the financial crisis and its stock prices dropped by 44 percent while millions of Americans watched in shock as their savings and retirement accounts took a nose dive. In fall 2008, even Apple, a company that had enjoyed strong sales growth over the past five years, began to cut production of its popular iPhone. Without jobs or cash, consumers would no longer flock to Apple’s fancy retail stores or buy a 3 prized iPhone. Things have turned around for Apple, which reported blockbuster sales for 2011 in part because of strong customer response to the iPhone 4S. But not all companies or individuals are doing so well. The economy is still struggling, unemployment is high (particularly for those ages 16 to 24), and home prices remain low. As you go through the course with the aid of this text, you’ll explore the exciting world of business. We’ll introduce you to the various activities in which businesspeople engage—accounting, finance, information technology, management, marketing, and operations. We’ll help you understand the roles that these activities play in an organization, and we’ll show you how they work together. We hope that by exposing you to the things that businesspeople do, we’ll help you decide whether business is right for you and, if so, what areas of business you’d like to study further. Saylor URL: 5 1 Jon Hilsenrath, Serena Ng, and Damian Paletta, “Worst Crisis Since ’30s, With No End Yet in Sight,” Wall Street Journal, Markets, September 18, 2008, (accessed January 21, 2012). 2 “How the Economy Stole the Election,”, (accessed January 21, 2012). 3 Dan Gallagher, “Analyst says Apple is cutting back production as economy weakens,”MarketWatch, November 3, 2008, production/story.aspx?guid=%7B7F2B6F99-D063-4005-87AD- D8C36009F29B%7D&dist=msr_1 (accessed January 21, 2012). 1.2 Getting Down to Business LEARNING OBJECTIVE 1. Identify the main participants of business, the functions that most businesses perform, and the external forces that influence business activities. A business is any activity that provides goods or services to consumers for the purpose of making a profit. When Steve Jobs and Steve Wozniak created Apple Computer in Jobs’s family garage, they started a business. The product was the Apple I, and the company’s founders hoped to sell their computers to customers for more than it cost to make and market them. If they were successful (which they were), they’d make a profit. Before we go on, let’s make a couple of important distinctions concerning the terms in our definitions. First, whereas Apple produces and sells goods (Mac, iPhone, iPod, iPad), many businesses provide services. Your bank is a service company, as is your Internet provider. Hotels, airlines, law firms, movie theaters, and hospitals are also service companies. Many companies provide both goods and services. For example, your local car dealership sells goods (cars) and also provides services (automobile repairs). Second, some organizations are not set up to make profits. Many are established to provide social or educational services. Such not-for profit (or nonprofit) Saylor URL: 6 organizations include the United Way of America, Habitat for Humanity, the Boys and Girls Clubs, the Sierra Club, the American Red Cross, and many colleges and universities. Most of these organizations, however, function in much the same way as a business. They establish goals and work to meet them in an effective, efficient manner. Thus, most of the business principles introduced in this text also apply to nonprofits. Business Participants and Activities Let’s begin our discussion of business by identifying the main participants of business and the functions that most businesses perform. Then we’ll finish this section by discussing the external factors that influence a business’s activities. Participants Every business must have one or more owners whose primary role is to invest money in the business. When a business is being started, it’s generally the owners who polish the business idea and bring together the resources (money and people) needed to turn the idea into a business. The owners also hire employees to work for the company and help it reach its goals. Owners and employees depend on a third group of participants— customers. Ultimately, the goal of any business is to satisfy the needs of its customers in order to generate a profit for the owners. Functional Areas of Business The activities needed to operate a business can be divided into a number of functional areas: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas. Management Managers are responsible for the work performance of other people. Management involves planning for, organizing, staffing, directing, and controlling a company’s resources so that it can achieve its goals. Managers plan by Saylor URL: 7 setting goals and developing strategies for achieving them. They organize activities and resources to ensure that company goals are met. They staff the organization with qualified employees and direct them to accomplish organizational goals. Finally, managers design controls for assessing the success of plans and decisions and take corrective action when needed. Operations All companies must convert resources (labor, materials, money, information, and so forth) into goods or services. Some companies, such as Apple, convert resources into tangible products—Macs, iPhones, iPods, iPads. Others, such as hospitals, convert resources into intangible products—health care. The person who designs and oversees the transformation of resources into goods or services is called an operations manager. This individual is also responsible for ensuring that products are of high quality. Marketing Marketing consists of everything that a company does to identify customers’ needs and designs products to meet those needs. Marketers develop the benefits and features of products, including price and quality. They also decide on the best method of delivering products and the best means of promoting them to attract and keep customers. They manage relationships with customers and make them aware of the organization’s desire and ability to satisfy their needs. Accounting Managers need accurate, relevant, timely financial information, and accountants provide it. Accountants measure, summarize, and communicate financial and managerial information and advise other managers on financial matters. There are two fields of accounting. Financial accountants prepare financial statements to help users, both inside and outside the organization, assess the financial strength of the Saylor URL: 8 company. Managerial accountants prepare information, such as reports on the cost of materials used in the production process, for internal use only. Finance Finance involves planning for, obtaining, and managing a company’s funds. Finance managers address such questions as the following: How much money does the company need? How and where will it get the necessary money? How and when will it pay the money back? What should it do with its funds? What investments should be made in plant and equipment? How much should be spent on research and development? How should excess funds be invested? Good financial management is particularly important when a company is first formed, because new business owners usually need to borrow money to get started. Figure 1.2 Business and Its Environment Saylor URL: 9 External Forces that Influence Business Activities Apple and other businesses don’t operate in a vacuum: they’re influenced by a number of external factors. These include the economy, government, consumer trends, and public pressure to act as good corporate citizens. Figure 1.2 "Business and Its Environment" sums up the relationship among the participants in a business, its functional areas, and the external forces that influence its activities. One industry that’s clearly affected by all these factors is the fast-food industry. A strong economy means people have more money to eat out at places where food standards are monitored by a government agency, the Food and Drug Administration. Preferences for certain types of foods are influenced by consumer trends (eating fried foods might be OK one year and out the next). Finally, a number of decisions made by the industry result from its desire to be a good corporate citizen. For example, several fast-food chains have 1 responded to environmental concerns by eliminating Styrofoam containers. As you move through this text, you’ll learn more about these external influences on business. (Section 1.3 "What Is Economics?" will introduce in detail one of these external factors—the economy.) KEY TAKEAWAYS  The main participants in a business are its owners, employees, and customers.  Businesses are influenced by such external factors as the economy, government, consumer trends, and public pressure to act as good corporate citizens.  The activities needed to run a business can be divided into five functional areas: 1. Management involves planning, organizing, staffing, directing, and controlling resources to achieve organizational goals. 2. Operations transforms resources (labor, materials, money, and so on) into products. 3. Marketing works to identify and satisfy customers’ needs. 4. Finance involves planning for, obtaining, and managing company funds. Saylor URL: 10 5. Accounting entails measuring, summarizing, and communicating financial and managerial information. EXERCISES 1. (AACSB) Analysis The Martin family has been making guitars out of its factory in Nazareth, Pennsylvania, factory for more than 150 years. In 2004, Martin Guitar was proud to produce its millionth instrument. Go to to link to the Martin Guitar Web site and read about the company’s long history. You’ll discover that, even though it’s a family-run company with a fairly unique product, it operates like any other company. Identify the main activities or functions of Martin Guitar’s business and explain how each activity benefits the company. 2. (AACSB) Analysis Name four external factors that have an influence on business. Give examples of the ways in which each factor can affect the business performance of two companies: Wal- Mart and Ford. 1 David Baron, “Facing-Off in Public,” Stanford Business, April 15, 2006, (accessed January 21, 2012). 1.3 What Is Economics? LEARNING OBJECTIVES 1. Define economics and identify factors of production. 2. Explain how economists answer the three key economics questions. 3. Compare and contrast economic systems. Saylor URL: 11 To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services. Resources: Inputs and Outputs Economics is the study of the production, distribution, and consumption of goods and services. Resources are the inputs used to produce outputs. Resources may include any or all of the following:  Land and other natural resources  Labor (physical and mental)  Capital, including buildings and equipment  Entrepreneurship Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labor transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) are needed for the production process. Entrepreneurship provides the skill and creativity needed to bring the other resources together to produce a good or service to be sold to the marketplace. Because a business uses resources to produce things, we also call these resources factors of production. The factors of production used to produce a shirt would include the following:  The land that the shirt factory sits on, the electricity used to run the plant, and the raw cotton from which the shirts are made  The laborers who make the shirts  The factory and equipment used in the manufacturing process, as well as the money needed to operate the factory  The entrepreneurship skill used to coordinate the other resources to initiate the production process and the distribution of the goods or services to the marketplace Saylor URL: 12 Input and Output Markets Many of the factors of production (or resources) are provided to businesses by households. For example, households provide businesses with labor (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to the same households that provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This circular flow is described in Figure 1.3 "The Circular Flow of Inputs and Outputs", which illustrates the dual roles of households and businesses:  Households not only provide factors of production (or resources) but also consume goods and services.  Businesses not only buy resources but also produce and sell both goods and services. Figure 1.3 The Circular Flow of Inputs and Outputs Saylor URL: 13 The Questions Economists Ask Economists study the interactions between households and businesses and look at the ways in which the factors of production are combined to produce the goods and services that people need. Basically, economists try to answer three sets of questions: 1. What goods and services should be produced to meet consumers’ needs? In what quantity? When should they be produced? 2. How should goods and services be produced? Who should produce them, and what resources, including technology, should be combined to produce them? 3. Who should receive the goods and services produced? How should they be allocated among consumers? Economic Systems Saylor URL: 14 The answers to these questions depend on a country’s economic system—the means by which a society (households, businesses, and government) makes decisions about allocating resources to produce products and about distributing those products. The degree to which individuals and business owners, as opposed to the government, enjoy freedom in making these decisions varies according to the type of economic system. Generally speaking, economic systems can be divided into two systems: planned systems and free market systems. Planned Systems In a planned system, the government exerts control over the allocation and distribution of all or some goods and services. The system with the highest level of government control is communism. In theory, a communist economy is one in which the government owns all or most enterprises. Central planning by the government dictates which goods or services are produced, how they are produced, and who will receive them. In practice, pure communism is practically nonexistent today, and only a few countries (notably North Korea and Cuba) operate under rigid, centrally planned economic systems. Under socialism, industries that provide essential services, such as utilities, banking, and health care, may be government owned. Other businesses are owned privately. Central planning allocates the goods and services produced by government-run industries and tries to ensure that the resulting wealth is distributed equally. In contrast, privately owned companies are operated for the purpose of making a profit for their owners. In general, workers in socialist economies work fewer hours, have longer vacations, and receive more health care, education, and child-care benefits than do workers in capitalist economies. To offset the high cost of public services, taxes are generally steep. Examples of socialist countries include Sweden and France. Free Market System Saylor URL: 15 The economic system in which most businesses are owned and operated by individuals is the free market system, also known as capitalism. As we will see next, in a free market, competition dictates how goods and services will be allocated. Business is conducted with only limited government involvement. The economies of the United States and other countries, such as Japan, are based on capitalism. How Economic Systems Compare In comparing economic systems, it’s helpful to think of a continuum with communism at one end and pure capitalism at the other, as in Figure 1.4 "The Spectrum of Economic Systems". As you move from left to right, the amount of government control over business diminishes. So, too, does the level of social services, such as health care, child-care services, social security, and unemployment benefits. Figure 1.4 The Spectrum of Economic Systems Mixed Market Economy Though it’s possible to have a pure communist system, or a pure capitalist (free market) system, in reality many economic systems are mixed. A mixed market economy relies on both markets and the government to allocate resources. We’ve already seen that this is what happens in socialist economies in which the government controls selected major industries, such as transportation and health care, while allowing individual ownership of other industries. Even previously communist economies, such as those of Eastern Europe and China, are becoming more mixed as they adopt capitalistic characteristics Saylor URL: 16 and convert businesses previously owned by the government to private ownership through a process called privatization. The U.S. Economic System Like most countries, the United States features a mixed market system: though the U.S. economic system is primarily a free market system, the federal government controls some basic services, such as the postal service and air traffic control. The U.S. economy also has some characteristics of a socialist system, such as providing social security retirement benefits to retired workers. The free market system was espoused by Adam Smith in his book The Wealth of 1 Nations, published in 1776. According to Smith, competition alone would ensure that consumers received the best products at the best prices. In the kind of competition he assumed, a seller who tries to charge more for his product than other sellers won’t be able to find any buyers. A job-seeker who asks more than the going wage won’t be hired. Because the “invisible hand” of competition will make the market work effectively, there won’t be a need to regulate prices or wages. Almost immediately, however, a tension developed among free market theorists between the principle of laissez-faire—leaving things alone—and government intervention. Today, it’s common for the U.S. government to intervene in the operation of the economic system. For example, government exerts influence on the food and pharmaceutical industries through the Food and Drug Administration, which protects consumers by preventing unsafe or mislabeled products from reaching the market. To appreciate how businesses operate, we must first get an idea of how prices are set in competitive markets. Thus, Section 1.4 "Perfect Competition and Supply and Demand" begins by describing how markets establish prices in an environment of perfect competition. Saylor URL: 17 KEY TAKEAWAYS  Economics is the study of the production, distribution, and consumption of goods and services.  Economists address these three questions: (1) What goods and services should be produced to meet consumer needs? (2) How should they be produced, and who should produce them? (3) Who should receive goods and services?  The answers to these questions depend on a country’s economic system. The primary economic systems that exist today are planned and free market systems.  In a planned system, such as communism and socialism, the government exerts control over the production and distribution of all or some goods and services.  In a free market system, also known as capitalism, business is conducted with only limited government involvement. Competition determines what goods and services are produced, how they are produced, and for whom. EXERCISES 1. If you started a business that made surfboards, what factors of production would you need to make your product? Where would you get them? Where would you find the money you’d need to pay for additional resources? 2. Which three key questions do economists try to answer? Will answers to these questions differ, depending on whether they’re working in the United States or in Cuba? Explain your answer. 1 According to many scholars, The Wealth of Nations not only is the most influential book on free- market capitalism but remains relevant today. 1.4 Perfect Competition and Supply and Demand Saylor URL: 18 LEARNING OBJECTIVE 1. Describe perfect competition, and explain how supply and demand interact to set prices in a free market system. Under a mixed economy, such as we have in the United States, businesses make decisions about which goods to produce or services to offer and how they are priced. Because there are many businesses making goods or providing services, customers can choose among a wide array of products. The competition for sales among businesses is a vital part of our economic system. Economists have identified four types of competition—perfect competition, monopolistic competition, oligopoly, and monopoly. We’ll introduce the first of these—perfect competition—in this section and cover the remaining three in the following section. Perfect Competition Perfect competition exists when there are many consumers buying a standardized product from numerous small businesses. Because no seller is big enough or influential enough to affect price, sellers and buyers accept the going price. For example, when a commercial fisher brings his fish to the local market, he has little control over the price he gets and must accept the going market price. The Basics of Supply and Demand To appreciate how perfect competition works, we need to understand how buyers and sellers interact in a market to set prices. In a market characterized by perfect competition, price is determined through the mechanisms of supply and demand. Prices are influenced both by the supply of products from sellers and by the demand for products by buyers. Saylor URL: 19 To illustrate this concept, let’s create a supply and demand schedule for one particular good sold at one point in time. Then we’ll define demand and create a demand curve and define supply and create a supply curve. Finally, we’ll see how supply and demand interact to create an equilibrium price—the price at which buyers are willing to purchase the amount that sellers are willing to sell. Demand and the Demand Curve Demand is the quantity of a product that buyers are willing to purchase at various prices. The quantity of a product that people are willing to buy depends on its price. You’re typically willing to buy less of a product when prices rise and more of a product when prices fall. Generally speaking, we find products more attractive at lower prices, and we buy more at lower prices because our income goes further. Figure 1.6 The Demand Curve Using this logic, we can construct a demand curve that shows the quantity of a product that will be demanded at different prices. Let’s assume that the diagram in Figure 1.6 "The Demand Curve" represents the daily price and quantity of apples sold by farmers Saylor URL: 20 at a local market. Note that as the price of apples goes down, buyers’ demand goes up. Thus, if a pound of apples sells for 0.80, buyers will be willing to purchase only fifteen hundred pounds per day. But if apples cost only 0.60 a pound, buyers will be willing to purchase two thousand pounds. At 0.40 a pound, buyers will be willing to purchase twenty-five hundred pounds. Supply and the Supply Curve Supply is the quantity of a product that sellers are willing to sell at various prices. The quantity of a product that a business is willing to sell depends on its price. Businesses are more willing to sell a product when the price rises and less willing to sell it when prices fall. Again, this fact makes sense: businesses are set up to make profits, and there are larger profits to be made when prices are high. Figure 1.7 The Supply Curve Now we can construct a supply curve that shows the quantity of apples that farmers would be willing to sell at different prices, regardless of demand. As you can see Saylor URL: 21

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