Ch4 The Company and the Economy.docx

Module 4 – The Company and the Economy 4.1 – The Company in the Economic Environment Environmental scanning: systematic study that provides information about PEST (Political, Economic, Social and Technological) and ETOP (Environmental threats and Opportunities) 4.2 – Revenue and Costs: The Basic Model Central issues of cost and revenue must be maintained as the focus of attention. The model is constructed by identifying the variables which determine revenue and costs and determining the factors which affect these variables. Revenue = Total Market x Market Share x Price Outlay = Number Workers x Wage Rate + Units of Capital x Price + Units of Material x Price The factors which affect the variables in the model include: Variable Determining Factors Total Market National Income, Population, Preferences, Competing Products, Product Life Cycle Market Share Price, Marketing expenditure, marketing strategies, competitors marketing expenditure and strategies. Price Demand conditions, competitive reaction, competitive advantage, market segmentation. Workforce Labor market conditions, wage rate offered, working conditions. Wage Rate Labor market conditions, unemployment rate. Capital Capacity of the capital goods sector. Capital Price Capital Market Conditions Materials Capacity of Suppliers Materials Price Materials Market Conditions. The model is useful for current products and future ones. The relative importance of the factors depend on the individual circumstances of the company. They are all dependent, for some extent, on the general state of economic activity. 4.3 – The Workings of the Economy It is necessary to distinguish between events and influences which are outside the control of the company and those which are the results of its own decisions. Example: if sales revenue unexpectedly declines, it could be a general economic downturn in business activity, or an inadequate marketing response to strategic moves by competitors. It is important to be aware of changes in the economy which may present opportunities or pose threats. Example: rise in interest rates. While it is true that many things are unpredictable, this is not a valid argument for ignoring them. Macroeconomic analysis is an important element of environmental scanning, and can provide the basis for strategic action. The main macroeconomics issues are: Determination of GNP and the effect of changes in demand and supply factors, full employment output, actual output, unemployment rate and inflation rate. Role of expectations. Money supply and the rate of interest. Rate of interest and investment expenditure. Factors affecting demand and supply of imports and exports. Determination of the exchange rate and international financial flows. 4.3.1 – Understanding and Using Economic Information Example in how to use economic data. A manufacturer of machine tools is working close to full capacity at the beginning of the current year. Should it increase or decrease capacity now? Last Year This year (early) Economic Indicator Change over year Recent changes Gross National Product 3.2% 0.5% Industrial Output 1.1% -1.5% Retail sales (volume) 4.3% -1.1% Investment expenditure -1.1% -3.2% Current Value Unemployment Rate 5.8% 6.2% Inflation Rate 9.3% 9.7% Wage inflation Rate 12.2% 10.0% Points to consider: Total output and consumer expenditure is increasing, but investment expenditure was declining and both prices and wages were increasing at a relatively high rate. Early this year there is a slow down. Growth in output ceased and both industrial output and consumer expenditure declined. Inflation rate stabilized. Unemployment rate increased and it helped reduce wage rate inflation. The increase in GNP in previous year is largely due to an increase in consumer expenditure (retail sales), there was a consumer boom. The consumer expenditure had not led to an increase in capital equipment, as investment expenditure had fallen. As industrial output had not grown as much as retail sales, companies must have been selling from inventories or imports must have increased. If we look the last year figures, we can calculate the impact on cash flow: Revenue = Total Market x Market Share x Price Revenue = 0.989 x 1 x 1.093 = 1.08 0.0989 = 1 – 0.011 (decrease in investment expenditure) 1 = market share, assumption is that it will not change 1.093 = 1 + 0.093 (inflation rate – it assume prices will change according to inflation) The same calculation can be done for Outlay, although the only figure we have is the wage inflation rate (1.122). If other costs are in line with wages, then outlay will increase by more than revenues, resulting in a reduction in net cash flow of about 4%. The increase in consumer expenditure might increase investment spending in the near future. In this case, the appropriate strategy could be to increase capacity now to be ready for the increase in investment demand. On the other hand, commentators mentioned that the government might increase interest rates, having an effect on economic activity in the short term. This is what we see in the early year numbers, with a further decline in investment expenditure, increased unemployment rate. 4.3.2 – Supply and Demand in Economy GNP (Gross National Product) – total value of goods and services produced in one year. Maximum output is constrained by the resources available. Potential or full employment GNP – when labor force is fully employed. Actual output – might be different than potential output. Can actual output exceed potential output? Yes, if there are shortages of labor and a great deal of overtime. Excess demand can increase inflation rate. The effect on the unemployment rate depends on the relative rates of growth of potential and actual output. There are three types of unemployment: Structural unemployment (large disruptions in the economy when whole industries close down), Frictional unemployment (people changing of jobs) and demand related unemployment (difference between actual and potential output). 4.3.3 – Unemployment and Inflation When the economy approaches full employment there is a pronounced tendency for supply bottle-necks to emerge, and as a result wage rates, capital costs and material prices tend to increase. On the other hand, when there is significant unemployment the wage rate is rarely observed to decline. Wage rates are “sticky”. Excess demand for final goods and services tends to push prices up. Taken together, these influences are known as “demand pull” inflation. Stagflation: high unemployment and high inflation. Philips Curve: relate unemployment with inflation (they follow opposite trends). The curve can shift over time. Expectations: once inflation existed in the economy, everyone expected that it would continue and made their forward contracts accordingly, causing the inflation rate to carry on unchanged although the unemployment rate was greatly increased. Monetary idea: keep the supply of money in check, removing the expectation that the government would accommodate inflation in the future. Inflation is difficult to get rid off, and expectations make it worse. In real life, there is a period of growing unemployment to check inflation. 4.3.4 – The International Economy Those which sell directly in foreign markets are continuously exposed to changes in trading conditions. Companies which sell only in domestic markets are open to competition from imports. Relative Inflation Rates: There can be substantial differences in the inflation rates in different countries which are not compensated for by changes in the exchange rate. If domestic rate continue at a higher level than the foreign rate, domestic costs can be expected to increase relative to foreign costs. What might be an attractive market at the moment may contain the seeds of disaster as relative costs increase. Exchange Rate Fluctuations: Exchange rate used to be determined by the demand and supply of the currency for imports and exports. Nowadays, however, the demand for and supply of currencies is dominated by international capital flows, which are currently about 80 times the value of payments for real trade flows. Exchange rates can change independent of the balance of trade. There is no guarantee that differences in relative inflation rates will be compensated for by changes in the exchange rate, and that the exchange rate will take care of costs disadvantages caused by a higher domestic price level. Exchange rates will consistently ‘overshoot’ and ‘undershoot’ because of capital flows. There are various methods of hedging bets in relation to exchange rates, for example buying currency forward. This makes it possible to predict some future cash flows, but it means that the company will not gain from any favorable movements in the exchange rate. It is not possible for a company to cover future exchange rates entirely, because cash flows will extend for years in the future, and these cash flows are difficult to predict with any degree of certainty. The Competitive Advantage of Nations The impact of the national environment on the competitiveness of individual companies is largely determined by the following influences: Domestic factor conditions – highly specialized resources develop in different countries over time (Silicon Valley) with a large pool of highly skilled manpower. Related and supporting industries – accessible suppliers. Demand conditions – sophisticated consumers force companies to innovate and shape their market orientations (Japanese cameras). Strategy, structure and rivalry – a country which fosters competition at home potentially breeds a strong core of companies which is capable of competing in the international arena. There are few instances of powerful international companies emerging from protected or subsidized home markets. A company must understand if is has a country specific or a company specific advantage. If the advantage is country specific then foreign markets can be exploited by exporting. If the advantage is company specific, it can invest in the country concerned provided that these advantages can be transferred from one country to another (management skills, production techniques). 4.4 – Forecasting: What Will Happen Next There are a great numbers of forecasts available, but they all share the same poor track record. There are a number of approaches to forecasting, ranging from the intuitive to the highly quantitative. There is virtually no connection between the statistical complexity of the forecasting models and their accuracy. The simplest approach to forecasting is to discover one statistic which serves as a reasonable indicator of what is likely to happen next, and this statistic is known as a leading indicator. A leading indicator is a statistic which signals when changes are about to happen in the economy, or in a particular industry. One approach is to think in terms of business cycles. A period of boom tend to be followed by period of depression, resulting in a cyclical pattern which is repeated over and over again. The business cycle has three components: the general trend over time (a positive or negative line), the underlying smooth cycle (the “real” cycle), and random fluctuations (ups and downs along the smooth cycle). Although no one is able to predict the business cycle with any degree of accuracy, it is possible to form a rational view as to whether the economy is in the upswing or the downswing. 4.5 – PEST Analysis Trends and events in the national and international economy need to be monitored because of their impact on the company. PEST = Political Economic Social Technological factors. 4.6 – Environmental Scanning The PEST analysis deals with what is known about the environment, but it is possible to take this a step forward by speculating about the future, given the limited information available at the moment. Environmental scanning is in a sense an attempt to predict well beyond the extrapolations of short term forecasting and market research type information. It serves as a kind of early warning system which, when it is correct, easily justifies the resources which it uses. 4.7 – Scenarios Once some projections of possible futures have been made they can be used as the basis of scenarios. Scenarios is not a forecast, but an attempt to investigate the implications of possible futures for the company. In some instances it may be based on a short run issue, such as the likely impact of a price reduction by a major competitor. 4.8 – The Economy and Profitability Factors like economic activity, inflation rate, exchange rate, affect profitability. 4.8.1 – Implications for Company Sales and Revenues GNP elasticity: the impact of changes in economic activity on the sales of a product. A product is elastic with respect to GNP when a 1% change in GNP leads to a greater than 1% change in the demand for the product. It is inelastic when the change is less than 1%. Example: potatoes are less affected by changes in GNP than high tech products. When product is elastic and GNP goes down, the only way to keep revenues is to increase market share. When the economy starts to grow strongly, an effective response might well be to concentrate resources on those products with a relatively high GNP elasticity. It is not only the size of GNP which is important, but also the distribution of national expenditure among its components. For example, a reduction in income tax, which leads to an increase in disposable incomes and hence to consumption expenditure, may be accompanied by a reduction in government expenditure, the net effect of which is to leave GNP unchanged. Increase of interest rate affects the demand for investment goods. 4.8.2 – Competitive Reaction and the Economic Environment It is also important to pay attention to how competitors will behave in the light of the changing circumstances. Will they react in the same way as our company? 4.8.3 – Implications for Inputs and Company Costs Using the variation of increase of demand due to GNP, we can make scenarios for cost. Inputs will change value as they are related to wage costs. Wages go up but are sticky. Look at GNP and calculate its affect on both the revenue and cost side of the equations. Companies that analyze economic events can take pre-emptive action/ 4.9 – Environmental Threat and Opportunity Profit: Part 1 One method of approaching this is to draw up a profile of how changes in the environment are likely to present threats and opportunities. This is a framework. Use the PEST approach as a checklist. Apply macroeconomic ideas to economy wide influences. Consider international factors both in terms of exchange rates and international competitive influences. Use the environmental scanning approach to think beyond the immediate situation. Put together some scenarios to help put factors into context. To put all this together into an ETOP, the following steps can be undertaken: List the relevant environmental factors which have been identified. Analyze whether each is likely to exert a positive or negative impact on potential sales and costs, or whether there appear to be openings for competitive response. Attempt to determine the relative importance of the threats and opportunities, and rank them accordingly. We analyze in a profile all the positive and negative points regarding revenue and costs. Example of an ETOP: Sector Threat or opportunity International - Expected appreciation of exchange rates + Growth in Eastern block economies Macroeconomic - Tax rate increase to fight inflation + Prospect of reduced interest rates Each point is then analyzed in more extension.