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Written by Steven Silbiger. Famous book for MBA's …

Written by Steven Silbiger. Famous book for MBA's

Source : Suraj Rana.

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  • 1. ContentsIntroductionDay 1MarketingDay 2EthicsDay 3AccountingDay 4OrganizationalBehaviorDay 5Quantitative AnalysisDay 6FinanceDay 7OperationsDay 8EconomicsDay 9StrategyDay 10MBA Mini-CoursesResearchPublic SpeakingNegotiatingInternational BusinessBusiness LawTen-Day MBA DiplomaAppendix: QuantitativeAnalysis TablesBibliographyMBAAbbreviation LexiconIndexAcknowledgmentsAbout the AuthorPraisefor the Ten-Day MBACopyrightAbout thePublisher
  • 2. IntroductionAfter I earned my MBA, I had a chance toreflect on the two most exhausting andfulfilling years of my life. As I reviewed mycourse notes, I realized that the basics ofan MBA education were quite simple andcould easily be understood by a wideraudience. Thousands of Ten-Day MBAreaders have proven it! Readers areapplying their MBA knowledge every day totheir own business situations. Not onlyuseful in the United States, The Ten-DayMBA has been translated into manylanguages around the world. So manypeople are curious about businesseducation, including doctors, lawyers,businesspeople, and aspiring MBAs. Thisbook answers their questions. The Ten-DayMBA really delivers useful information
  • 3. quickly and easily. Current MBA studentshave written me that they even use thebook to review for exams. Ten-Day MBAsare “walking the walk and talking the talk”of MBAs every business day. It’s proventhat this book can work for you. Written forthe impatient student, The Ten-Day MBAallows readers to really grasp thefundamentals of an MBA without losing twoyears’ wages and incurring an $80,000debt for tuition and expenses.Prospective MBAs can use this book to seeif a two-year investment is worth their while;those about to enter business school canget a big head start on the competition; andthose of you who cannot find the time orthe money can get at least $20,000 of MBAeducation at 99 percent off the list price.Unfortunately, this book cannot provide you
  • 4. with the friendships and lifelong businesscontacts that you can develop at an eliteschool. However, it can impart many of theskills that make MBAs successful.The Ten-Day MBA summarizes theessentials of a Top Ten MBA education.The mystique and the livelihood of the TopTen business schools are predicated onmaking their curriculum appear as uniqueand complex as possible. Companies paythousands of dollars to send theirexecutives to drink from these hallowedfountains of knowledge for a few days. Ispent two years of my life not only drinkingfrom the fountain but also bathing andwashing my clothes in it.Which schools are included in the Top Tenis a subject of considerable debate, asdisplayed by the recent rankings shown at
  • 5. the end of this introduction. The Top Tenactually refers to a group of fifteennationally recognized schools that playmusical chairs for Top Ten ranking. Theydistinguish themselves by long applicationforms, active alumni networks, long lists ofrecruiters, and the ability of their graduatesto demand and receive outrageous startingsalaries. The Top Ten schools require ofcandidates at least two years’ workexperience before admission. Experiencedstudents can enrich class discussions andstudy groups. A great deal of my learningcame from my classmates’ workexperiences.The Top Ten schools do not necessarilyoffer the best teaching, facilities, orcurriculum. Reputation plays a great part intheir status. A variety of rating books are
  • 6. available that give the “inside” story onthose reputations. According to the 1998Business Week poll, “racking up thehighest satisfaction scores from graduatesare, in descending order, UCLA,Pennsylvania, Michigan, Cornell andCarnegie Mellon.” The recruiters’ rankings,on the other hand, are Pennsylvania,Northwestern, Chicago, Columbia, andMichigan.My aim is to cut to the heart of the top MBAprograms’ subject matter clearly andconcisely—the way only an MBA can, andthe way academics would not dare. Tocover the major concepts, I use examplesand outlines and summarize whereverpossible. I slice through the long-windedand self-serving academic readings that attimes I had to trudge through. This book
  • 7. contains only the pearls of wisdom buriedin my thirty-two binders of cases, coursematerials, and notes.I have no vested interest in promoting anyof the business theories presented in thebook. Therefore, this book does not repeatthe same idea over the course of twohundred pages as many popular businessbooks have a tendency to do. I crystallizethe most important concepts in briefpassages so you can learn and rememberthem without losing interest.From my interviews with graduates fromWharton, Harvard, Northwestern, and othertop schools, I learned that all of theirprograms serve up the same MBA meal.Only the spices and presentations of thebusiness banquets vary.
  • 8. The basics of MBA knowledge fall into ninedisciplines. Some schools have carefullycrafted their own exalted names for eachsubject, but their unglorified names are:MarketingEthicsAccountingOrganizational BehaviorQuantitative AnalysisFinanceOperationsEconomicsStrategyThe synthesis of knowledge from all ofthese disciplines is what makes the MBA
  • 9. valuable. In the case of a new productmanager with an MBA, she can not onlysee her business challenges from amarketing perspective, but she canrecognize and deal with the financial andmanufacturing demands created by hernew product. This coordinated,multidisciplinary approach is usuallymissing in undergraduate businesscurricula. By learning about all the MBAdisciplines at once, in one book, you havethe opportunity to synthesize MBAknowledge the way you would at the bestschools.When MBAs congregate, we tend toengage in “MBA babble.” Our use ofmystical abbreviations like NPV, SPC, andMBO is only a ruse to justify our loftysalaries and quick promotions. Please do
  • 10. not be intimidated. MBA jargon is easy tolearn! As you read this book, you too willbegin to think and talk like an MBA.My goal is to make you familiar with thesignificant MBA tools and theories currentlybeing taught at the leading businessschools and to help you understand anddevelop the MBA mind-set. When youfinish the ten days, please feel free to fill inyour name on the diploma at the end of thebook. It serves as evidence of yourscholarship and you should proudly displayit for all your friends to see.Current MBA School RankingsBelow are the most current rankings ofMBA programs. Although the rankingschange from year to year, the sameschools are consistently listed. Schoolnames listed in parentheses immortalize
  • 11. founders and major benefactors. Two-Year MBA Degree ProgramsU.S. News & World Report, March 1998:1. Harvard1. Stanford3. Columbia3. MIT (Sloan)3. Pennsylvania (Wharton)6. Chicago6. Northwestern (Kellogg)8. Dartmouth (Tuck)8. UCLA (Anderson)10. Virginia (Darden)10. Berkeley (Haas)
  • 12. 10. Michigan10. Duke (Fuqua)(Several ties in rankings)Business Week, October 1998:1. Pennsylvania (Wharton)2. Northwestern (Kellogg)3. Chicago4. Michigan5. Harvard6. Columbia7. Duke (Fuqua)8. Cornell9. Stanford10. Dartmouth (Tuck)11. Virginia (Darden)
  • 13. 12. UCLA (Anderson)13. NYU (Stern)14. Carnegie Mellon15. MIT (Sloan)The Insider’s Guide to the Top TenBusiness Schools:ChicagoColumbiaDartmouth (Tuck)HarvardMIT (Sloan)MichiganNorthwestern (Kellogg)Pennsylvania (Wharton)Stanford
  • 14. Virginia (Darden)This book by Tom Fischgrund (1993)provides excellent in-depth profiles of eachschool, written by graduates. Within theTop Ten, the schools are not ranked. Nondegree Executive MBA EducationBusiness Week, October 1997:1. Harvard2. Michigan3. Northwestern (Kellogg)4. Pennsylvania (Wharton)5. Stanford6. Virginia (Darden)
  • 15. 7. Columbia8. INSEAD (French school)9. Duke (Fuqua)10. MIT (Sloan)11. Chicago12. IMD (Swiss school)13. North Carolina (Kenan-Flagler)14. Dartmouth (Tuck)15. Indiana Day 1 Marketing Marketing TopicsThe 7 Steps of Marketing StrategyDevelopment
  • 16. The Buying ProcessSegmentationProduct Life CyclePerceptual MappingMarginsThe Marketing Mix and the 4 P’sPositioningDistribution ChannelsAdvertisingPromotionsPricingMarketing EconomicsA scene from the boardroom of AcmeCorporation:
  • 17. DIRECTOR: Every time we do our annualreview of our executives’ salaries, I cringewhen I think that we are paying more to JimMooney, our vice-president of marketingfrom Ohio State, than to our company’spresident, Hank Bufford from Harvard. I justdon’t understand it.CHAIRMAN OF THE BOARD: What don’tyou understand? Without Jim’s sales wewouldn’t need a president—or anyone elsefor that matter!
  • 18. Marketers see the world like the chairmanof Acme. As renowned Professor PhilipKotler of the Kellogg School atNorthwestern teaches, marketing comesfirst. Marketing integrates all the functionsof a business and speaks directly to thecustomer through advertising, salespeople,and other marketing activities.Marketing is a special blend of art andscience. There is a great deal to be learnedin marketing classes, but no amount ofschooling can teach you the experience,the intuition, and the creativity to be a trulygifted marketer. That’s why those with thegift are so highly paid. Formal educationcan only provide MBAs with a frameworkand a vocabulary to tackle marketingchallenges. And that is the goal of thischapter and of the numerous expensive
  • 19. executive seminars conducted by theleading business schools.The top schools prepare their students forexecutive marketing positions—in spite ofthe fact that their first jobs will likely be aslowly brand assistants at large food or soapcompanies. Therefore, the core curriculumstresses the development of full-fledgedmarketing strategies instead of thetechnical expertise needed on an entry-level job out of MBA school.Numbers-oriented students tend to viewmarketing as one of the “soft” MBAdisciplines. In fact, marketers use manyquantitative or “scientific” techniques todevelop and evaluate strategies. The “art”of marketing is trying to create andimplement a winning marketing plan. Thereare literally an infinite number of
  • 20. possibilities that may work. McDonald’s,Burger King, Wendy’s, Hardee’s, and WhiteCastle successfully sell burgers, but they alldo it in different ways. Because there areno “right” answers, marketing classes canprovide students with either an opportunityto show their individual flair, or many hoursof frustration as they try to come up withcreative ideas. Marketing was my favoritesubject. It was fun cooking up ideas fordiscussion. My B-school buddies still kidme about the time I proposed to the classthat Frank Perdue introduce a gourmetchicken hot dog. The Marketing Strategy ProcessThe marketing process is a circularfunction. Marketing plans undergo manychanges until all the parts are internally
  • 21. consistent and mutually supportive of theobjectives. All aspects of a proposal needto work together to make sense. It is veryeasy to get one part right, but an internallyconsistent and mutually supportivemarketing plan is a great accomplishment.It’s a seven-part process.1.Consumer Analysis2.Market Analysis3.Review of the Competition and Self4.Review of the Distribution Channels5.Development of a “Preliminary” Marketing Mix6.Evaluation of the Economics7.Revision and Extension of Steps 1-6 until a consistent plan emergesAlthough there are seven steps, their orderis not set in stone. Based on circumstancesand your personal style, the order of the
  • 22. steps may be rearranged. This chaptercould get bogged down in a morass ofmarketing theory, but to make it practical, Iwill outline the questions and areas thatshould be considered when developing amarketing plan. For expediency, I willconcentrate on product marketing, but thesame frameworks and vocabulary are alsoapplicable to service marketing.I will present the MBA models in the sameseven-step order in which they are taughtat the best schools. This chapter offers ageneric structure to apply to whatevermarketing issue you may encounter. I havenot neglected to use the vocabulary taughtat the schools, so you can pick up on theMBA jargon and speak like a real MBAmarketer. Marketing is an area especiallyrich in specialized vocabulary. With the
  • 23. correct vocabulary, even your mediocremarketing ideas can appear as brilliantones. That may sound funny, but that’s theway ad agencies market their product,advertising.1. Consumer AnalysisConsumer Analysis Market CompetitionDistribution Marketing Mix EconomicsReviseAll marketing plans should begin with alook at the all-important “consumer” and hisor her needs. People do not have the sameneeds or desires. The objective ofconsumer analysis is to identify segmentsor groups within a population with similarneeds so that marketing efforts can bedirectly targeted to them. Starting anywhereelse tends to restrict your thinking and allsubsequent analysis. Several important
  • 24. questions must be asked to find the marketthat will unlock untold marketing riches:What is the need category?Who is buying and who is using theproduct?What is the buying process?Is what I’m selling a high- or low-involvement product?How can I segment the market?What is the need category? Who needs usand why?What is the need or use that your productaddresses? The question may seemunnecessary, but in answering it you mayuncover a potential market for the productthat was previously overlooked. That is whythis question has to be addressed first,
  • 25. before you begin to pollute your mind withconventional thoughts. The people at Arm& Hammer baking soda have done a greatdeal of this type of analysis. They havemade use of their powder in their ownbrand of toothpaste, air freshener, andcarpet freshener. In addition, they profitablyrecommend their raw baking soda powderfor hundreds of uses.Marketing Strategy Development
  • 26. Who is buying vs. who is using theproduct?Buyers many times are different fromusers. Women, for example, make themajority of purchases of men’s underwearand socks. If an advertising campaignwanted to target the buyer of men’s socks,
  • 27. it probably would be inappropriate to buyspace in Sports Illustrated. Determining thebuyer as well as the user provides theessential initial insights to create amarketing plan.What is the buying process?Once you have established the need, andwho is making the purchases, you shouldtry to form a hypothesis on how the productis bought. Marketing research is a primesource of information, but just as valid areyour own observations, investigation, andintuition.Understanding the buying process is criticalbecause it will lead to the possible routes toreach buyers. The buying process includesall the steps that a person takes leading toa purchase. It is also called the adoptionprocess and the problem-solving process
  • 28. by some academics. Some researchers callit a Learn/Feel/Do process. Others call itAIDA for Attention/Interest/Desire/Action. Ihave read extensively on this topic andhave boiled the theories down to five steps.For any particular product, the buyingprocess can include one or all of thefollowing steps:Awareness Information Search EvaluateAlternatives Purchase EvaluateIn the instance of a soap purchase, theprocess would look like this:Smell Body What Should I Use? Soap?Ask Wife for Advice Make Trip to the StoreRead Labels Buy Dial Soap Bathe SmellBody for Odor Buy Dial Soap Next TimeThe steps of the buying process explained:
  • 29. Awareness (Interest, Problem Recognition).“I might need something.” At some point aperson will realize a need, like the need touse soap. Advertising may trigger thatneed. Prestige products such as designerclothes and fragrances trigger desire. Theymeet emotional needs such as love andgroup acceptance. Head & Shoulders preyson the fear of a loss of love and groupacceptance. You need to ask yourself,“How do consumers become aware of myproduct?” “Where are my targets likely tobe exposed to my message?”Information Search. “Sounds good, let mefind out more about it.” People involved inpurchase decisions are confronted withinformation from a variety of sources:Consumer Reports, salespeople, specialtymagazines, family, friends, and local
  • 30. experts. As a marketing manager, you wantyour target market to get as muchfavorable information as possible aboutyour product when and where buyers maketheir buying decisions. For example, storedisplays play that role at the point ofpurchase (POP). Cover Girl Cosmetics hasa display in drug stores to help buyersselect colors. For the same purpose, EstéeLauder has its Clinique ladies indepartment stores to do its talking.Evaluate the Alternatives. Which one isbest for me? This includes not onlyproducts within a category, but substitutesas well. When confronted with the highprices of automobiles, a college studentmay end up buying a motorcycle, a moped,or a bicycle. Depending on the importanceof the product, consumers may seek
  • 31. additional information and advice. Carpurchases often include a trip to the localmechanic or the neighborhood car buff.Placing positive information where yourbuyers are likely to look is one key tomarketing success.At this stage of the buying process themarketing manager would like to identifythe influencers of his target’s buyingbehavior. In the golf industry the club pro isa key influencer in the equipment-buyingdecision of golfers. If you can sell the pro,you can sell to the club’s members.Distribution is also crucial at the evaluationstage of the buying process. If a product isnot readily available, a comparablesubstitute may be chosen just forconvenience or immediacy of need. Coca-Cola and Pepsi’s wide distribution make it
  • 32. tough for any new cola competitor to everbe any more than a fringe brand. Even ifyou crave Dr. Brown’s Creme Soda, youprobably will accept a Coke or a Pepsiwhen you’re thirsty at the beach.The Purchase Decision. This is the bigsale. Even though the decision to buy couldbe “yes,” in certain instances the firstpurchase is only a trial. Adoption of “newand improved” Bounty paper towels as yourregular brand occurs only after a successfultest with those tough spills. With many big-ticket items, such as ocean cruises andappliances, a trial is not possible. In thoseinstances the decision process is moretime-consuming and difficult to makebecause there is more risk involved. It isvery important for the marketer tounderstand risk. Through the use of a
  • 33. number of marketing tools, such asadvertising, knowledgeable salespeople,warranties, and printed materials, purchaserisk can be reduced by offering the buyerinformation explaining what level of performance he or she can expect, as well asproviding a basis of comparison withcompeting products.Evaluate (Postpurchase Behavior). Did Imake a mistake? This conclusion can bereached either on a physical level bytesting the product’s efficacy or on apsychological level by checking for peerapproval. Buyer’s remorse andpostpurchase dissonance are terms todescribe the period of confusion that oftenfollows a purchase. Automobile advertising,for example, is not only targeted atpotential buyers, but also at recent buyers
  • 34. to reassure them that they didn’t screw upwhen they bought a Dodge Caravanminivan instead of a Honda Odyssey.In trying to understand the buying process,the first sparks of a marketing plan can beignited into a tentative idea aboutadvertising or promotion (to be consideredlater in Step 5 of the strategy developmentprocess).Research Can Help to Understand theBuying Process. Consumer research is amajor tool in helping make the buyingprocess theory useful. Research can showa marketing director where he hassucceeded and where his efforts need tobe redirected. For example, if the marketingdirector of The National, a sportsnewspaper that failed in 1991, had
  • 35. conducted a survey that would have shownhim that 50 percent of men were aware ofthe paper, but that only 1 percent had readit, that could have been useful. That findingcould have led the director to increase hisefforts to gain wider newsstand distributionand to give more trial subscriptions.Research is valuable because it can betranslated into tangible marketing actions.Before you embark on research, you mustask yourself:“What specific question do I needanswered?”“How am I going to use the informationonce I have it?”If you haven’t thought through these twosimple questions, you will probably wasteyour time and money. I can assure you thatmany marketing research companies will
  • 36. be glad to help you waste money.Is the product a high- or a low-involvementproduct?As the discussion of buyer behaviorindicates, different products elicit differentpurchase behaviors because of theirinherent importance to the buyer and user.If the consumer feels a high level of “risk” inbuying a product, then it is considered ahigh-involvement product. There areseveral reasons for high-involvementpurchase decisions:High priceThe need for the product’s benefit (e.g.,reliability, as in the case of a pacemaker)The need for the product’s psychologicalreward (e.g., status, love)
  • 37. Stereos, clothing, cars, and professionalservices are examples of high-involvementpurchases. They are usually higher pricedand at times difficult to compare.Determining the differences betweenalternatives makes high-involvementpurchases difficult, especially if the buyer isnot an expert. Thus, the information searchcan be quite extensive. When litigating adamage claim, for example, usually there isno second chance to take the case to trial.Therefore, the choice of a lawyer is a high-involvement selection. With low-involvement products the decision issimpler. For example, if a candy bar isn’ttasty, you can always pitch it and buyanother one.
  • 38. A helpful matrix on page 10 captures thepossible behaviors resulting from theinteraction of the levels of involvement andproduct differences. By understanding thepossible behaviors, you, as a marketer,may be able to take advantage of thisknowledge to sell your product.This academic model does have real-worldimplications for action. A high-involvementproduct, such as a Harley-Davidsonmotorcycle, would appear in the upper left-hand corner of the matrix. The model wouldsuggest that Harley’s marketing effortsshould be geared toward demonstrating itstechnical superiority, but also include anemotional appeal—“buy an Americanclassic”—to engender loyalty.The marketer’s magic is at work when he orshe transforms a previously low-
  • 39. involvement product into a high-involvement one. Athletic shoes are aprime example. Once just functional shoesfor gym class, sports shoes have become astatus symbol for young people and eventhe cause of murder on inner-city streets.The conversion of a low-involvementproduct to a high-involvement product canmake a simple commodity product standout against an undifferentiated field ofcompetitors. There are four generic ways inwhich this can be accomplished.CONSUMER BEHAVIOR MATRIX
  • 40. Adapted from Henry Assael, ConsumerBehavior and Marketing Action, 4th ed.(Boston: PWS-Kent Publishing Co., 1992),p. 100.Link Product to a High-Involvement Issue .Linking Procter & Gamble’s Puritan no-cholesterol cooking oil to a wife’s fear of ahusband’s heart attack is a classic exampleof an advertising ploy.Use Involving Advertising. If the advertisingcreates a value-expressive message about
  • 41. the product or service, then a product canbecome important. Such messages linkvalues, such as social status and love,instead of promoting physical productattributes to differentiate the product fromthe competition. Pepsi tries to link beingmodern and youthful with its products byusing singers in elaborate commercials tosell its soda.Change the Importance of Product Benefits. Products as well as services provide avariety of benefits. If through marketingaction a benefit can be raised to aheightened level of importance, buyers arelikely to become more involved. The beerwars of the 1980s made calories animportant competitive issue. An overlookedattribute—calories—made health-consciousdrinkers more aware of their purchasing
  • 42. decisions, and consequently Miller Litemade out like a bandit.Introduce Important Characteristic toProduct. A marketer can also tinker withsome of the elements of the product itselfto distinguish it. When childproof caps wereintroduced on household cleaners, theinvolvement of parents in this purchasedecision was heightened. The first productswith protection caps stood out on the storeshelves. But once all competitors copiedthe cap, new avenues of differentiationwere needed and the purchase returned toits low-involvement status.Truly low-involvement products often arethat way because a minimum level ofacceptable performance is required. Athumbtack, for example, does not have a
  • 43. very difficult job to perform. No matter whatthe brand, you can’t go too wrong. If thecost of trial is low, such as for a pack ofgum, involvement is difficult to stimulate.Related to involvement is the level ofpurchase planning. Is the purchaseplanned or an impulse buy? High-involvement products are usually plannedwhile impulse products are bought on thespur of the moment. If a purchase isplanned, then a buyer is likely to seekinformation. If not, the proximity of theproduct to the need is very important.Snack foods are an example of impulsebuying. Midday hunger leads to the nearestjunk food.Do I intend to segment the market? Why?How?
  • 44. I skirted around this issue in the buyerbehavior section, but the question “Who isour consumer?” is central to the marketingtask. If you think you have something thatis for everyone, then a mass marketstrategy is appropriate. If your productsatisfies the masses, then feed it to them. Ifnot, you must choose a segment orsegments of the market to target.Segments are homogeneous groups ofsimilar consumers with similar needs anddesires. For instance, Coca-Cola uses amass-market approach to get everyonedrinking the “real thing.” Orangina, aspecialty soda, appeals to a more narrowlydefined market segment. It’s priced higherand its bottle is shaped differently.Orangina appeals to a special segment ofthe soft drink market.
  • 45. Segmentation of the market serves thefollowing functions:To identify segments large enough to serveprofitably.To identify segments that can be efficientlyreached by marketing efforts.To help develop marketing programs.By having a definite segment in mind, youcan effectively aim and efficiently executeyour marketing activities to yield the mostsales and profits. Without a target, you riskwasting marketing dollars on disinterestedpeople. There are four major segmentationvariables used in segmenting consumermarkets:
  • 46. - Geographic- Demographic- Psychographic- BehavioralGeographic Segmentation. Divides themarket by country, state, region, county,and city. The federal census lists 310Standard Metropolitan Statistical Areas(SMSAs) to define the major geographicpopulation centers of the United States.Arbitron, a large media research firm, hasdefined a similar measure to capture the210 major television markets of the country,called Areas of Dominant Influence (ADIs).A. C. Nielsen, a competitor, has a similarmeasure called Designated Market Areas(DMAs).
  • 47. Demographic Segmentation. Divides apopulation based on the followingmeasurable variables to reach ahomogeneous group of people:Age—Different generations’ different wantsand needsSex—Gender use and buying patternsIncome—The ability to purchaseMartial Status—Family needsFamily Life Cycle—Starting out, emptynesters, etc.Education/Occupation—An indication of thesophistication of the consumerEthnicity, Religion, and Race—Particulartastes and preferences
  • 48. Psychographic Segmentation. Divides themarket by psychological differences:Life-style—Activities, interests, andopinionsPersonality—Conservative, risk-taking,status-seeking, compulsive, ambitious,authoritarian, gregarious. (People mayhave different hot buttons that advertisingcan try to trigger.)Psychographic segmentation is difficult.Personality variables are tougher to identifyand quantify than demographics, but theycan be very valuable.
  • 49. Behavioral Segmentation. Divides themarket by observable purchase behaviors:Usage—Amount of use, manner of use,benefits soughtPurchase Occasion—Gift, vacation,seasonal, etc.Brand Loyalty—Loyalty to one productindicates receptiveness to others.Responsiveness to Price and Promotion—Some groups respond to specialmarketing efforts more than others.Housewives use more coupons than singleprofessional women.Marketers must not only select the “right”group of variables but also decide howmany to use. The correct number of
  • 50. “useful” variables will identify the mostaccessible and receptive target, not themost specific. For example it is possible todescribe a target segment for Corvettes asbrown-haired, male, twenty-five to sixty-fiveyears old, with income over $50,000.However, the ability to target just brown-haired men with effective advertising islimited and its usefulness would bedubious. Is brown hair a necessarysegmentation variable? There are nomagazines exclusively targeted to brown-haired males. Besides, blond andredheaded men may also be a reasonablemarket for Corvettes. You should use thefollowing criteria to evaluate possiblemarketing segments:
  • 51. Measurability—Can you identify thesegment? Can you quantify its size?Accessibility—Can you reach the segmentthrough advertising, sales force ordistributors, transportation, orwarehousing?Substantiality—Is the segment largeenough to bother with? Is the segmentshrinking, maturing, or is it a growingsegment?Profitability—Are there enough potentialprofits to make targeting it worthwhile?Compatibility with Competition—Are yourcompetitors interested in this segment? Arecompetitors currently investigating it or is itnot worth their trouble?Effectiveness—Does your company havethe capabilities to adequately service this
  • 52. segment?Defendability—Can you defend yourselfagainst a competitor’s attack?With that theoretical background, here’s asample demographic profile of gourmetcoffee buyers that marketers actually use:Twenty-five to fifty-four years oldCollege educatedProfessional or business executiveemploymentChildless householdsHousehold incomes greater than $50,000This “yuppie” market segment ismeasurable, accessible, large, and
  • 53. profitable. Consequently, many large coffeecompanies continue to target it.Even in markets that appear hopeless,there may be a segment that othersoverlook. Xerox controlled 88 percent of thecopier market in the 1970s. The majority ofits sales came from large and medium-sized units. But by 1985, Xerox had lostmore than half of its market share. Whathappened? Xerox ignored the small-copiermarket. Thousands of small companieswith light copy needs had to run to the localcopy shop every time they had a copy job.Canon, Sharp, and Ricoh seized thismarket by selling a smaller and lessexpensive copier. With a foothold in smallcopiers, the Japanese competitorsproceeded to topple Xerox in the large-copier segment of the market.
  • 54. Consumer analysis serves to “prime thepump” when you need to form acomprehensive marketing strategy. Do itfirst so as not to stifle your creativity withthe quantitative analysis you will perform aspart of the strategy developmentframework. On a first pass, you can makean “intuitive” choice of a target segment.After the other steps are completed it canbe altered to fit an evolving marketingstrategy.2. Market AnalysisConsumer Market Analysis CompetitionDistribution Marketing Mix EconomicsReviseWhile segmentation analysis focuses onconsumers as individuals, market analysistakes a broader view of potentialconsumers to include market sizes and
  • 55. trends. Market analysis also includes areview of the competitive and regulatoryenvironment. By closely examining themarket, a marketing manager candetermine if the segment selected is worththe trouble of a targeted marketing effort.MBAs ask three important questions toevaluate a market:What is the relevant market?Where is the product in its product lifecycle?What are the key competitive factors in theindustry?What is the relevant market?The easiest mistake to make is to believethat your relevant market includes the totalsales of your product’s category. In
  • 56. between the first and second years of myMBA education, I worked for aninternational trading company. Iinvestigated the possibility of selling aMexican gourmet ground coffee in stores. It would have beenmisleading for me to assume that all coffeesales were in my relevant target market.Approximately $11 billion of coffee wassold in the United States in 1990. However,60 percent of that total was sold in stores,while the other 40 percent was sold to theinstitutional markets, including restaurantsand vending machines. That left me with aretail market of $6.6 billion.But within that larger coffee market therewere additional sub-markets to investigatebefore arriving at my final relevant market.The gourmet coffee market accounted for
  • 57. $750 million, or 11 percent of the retailmarket’s sales. Within the gourmet coffeemarket, only 60 percent of the coffees soldhad no artificial flavorings. My Mexicancoffee had no additives and the producerrefused to artificially flavor his coffee.Therefore, my relevant market was furtherreduced to $450 million. But of that marketslice, only 55 percent was sold insupermarkets. That left me with a $248million market. That was my relevantmarket.Once a market segment is identified, youhave to ask if it is large and accessibleenough to justify your marketing effort. Ifthe answer to that question is no, then youhave what is called a “makable” product,but not a “marketable” one. Onlymarketable products make money.
  • 58. These questions are difficult to answer andinvolve marketing research. If it is a newproduct, the answers will not be readilyavailable. Test markets may have to beused to obtain that information. This stepmay lead to further segment investigation.The growth and decline of consumersegments within a market should also benoted. When the market is growing, futuresales growth can come from new users orexisting customers. If the pie is shrinking,any sales growth has to come out of yourcompetitors’ hide, and they’ll fight you formarket share! Following the demographictrends to attract a growing senior citizenmarket, Lederle Laboratory, themanufacturer of Centrum vitamins, made avery minor reformulation in 1990, andsuccessfully introduced its “Silver” formula.
  • 59. Where is the market in its product lifecycle?Markets can be characterized by the stagethat they are at in their product life cycles(PLC). Instead of being merely a factor oftime, the PLC describes how a product’ssales grow as new segments becomeaware and begin buying it. Cellular phoneservice began in the early 1970s with fewerthan ten thousand users. But it wasn’t untilthe 1990s, when the prices dropped andmany could afford a unit for their cars, thata multisegment market of over six millionusers emerged.The PLC concept is important because theprocess of diffusion or adoption by thepopulation has major implications for how aproduct is marketed. Each productdevelops its own unique PLC as it matures.
  • 60. Understanding the PLC can give you anMBA insight that your competitors maylack.The four generic stages of the PLC andtheir implications for action are:Stage 1: Introduction, “What is it?”Awareness and education are needed. Ifpossible a trial is important. Highadvertising costs may be incurred to get theword out. Some vendors opt for anexclusive distribution of their products in afew select outlets at first. Initiallycompanies make frequent product changesas customers’ needs become known. Thefirst buyers are called the innovators,followed by the early adopters. They freelytake purchase risks because theirpersonalities or pocketbooks allow them to
  • 61. do so. When companies introduce newproducts, managers must make difficultpricing decisions because there isfrequently no basis for comparison. Thelevel of initial prices and profits has greatimplications regarding the outcome offuture battles with competitors as well asyour ability to perform additional researchand development (as with products likehigh-definition TV and DVD).Stage 2: Growth, “Where can I get it?”Education is still important, but at this stagecompetition is intensified. The earlymajority becomes interested. As moreconsumers become familiar with a productthey examine the new models to decidewhich to buy, not whether they should buy.When buyers get to the store they start
  • 62. comparing features. To make the productmore accessible, marketers often choose aselective distribution to gain a greaternumber and variety of outlets. At this stageit is important to boost your sales volumeahead of the competition in order to reducecosts through production and advertisingefficiencies. This helps a company gain thecompetitive advantage in the next stage ofthe PLC (e.g., palm organizer).Stage 3: Maturity, “Why this one?” At thisstage the late majority of the mass marketbuys. Because people are accustomed tobuying the product and the differences arefew, brand loyalty plays a dominant role.Price competition often becomes heated instable markets because additional marketshare comes directly from your
  • 63. competitors. The product’s features thatwere so important in the growth stage havebecome standardized. Because there isless differentiation on product attributes,advertising is used as a vehicle todifferentiate products. Marketing managerstry to segment their target market as muchas possible to meet specific unmet consumer needs. In mature marketscompetitors are ferreting out all possiblesegments. All possible channels ofdistribution are also considered using amass market distribution strategy (e.g., CDplayers, VCRs).The Product Life Cycle
  • 64. Stage 4: Decline, “How much?” As aproduct ages in its PLC, it is likely that itscompetitors offer similar products. Even themost timid consumers, the laggards, find itsafe to buy the product at this late stage. (Ifit does cause cancer, the FDA usually hasfound out by now.) Consumers turn a deaf
  • 65. ear to advertising because they know thatall competing products are the same. Atthis stage many companies focus theirefforts on reducing price if competitionremains, or slowly increasing prices if thecompetitive field thins. Trade relations arekey to staying on the retail shelf at thispoint, because without the excitement ofnovelty, distributors and retailers wouldrather allocate space to newer andpotentially more profitable products. Theeffort to sell the trade is popularly calledrelationship marketing (e.g., black-and-white TVs, phonographs, and cassettes).With some products the maturity phasedoes not necessarily mean death. Productscan be reinvigorated after a period ofmaturity and a new growth phase canbegin. Baseball trading cards underwent
  • 66. such a revival, encouraged by Topps Inc.’smarketing efforts in the 1980s, and losttheir luster in the 1990s.In some cases, lingering death throesproduce large profits for the lastmanufacturer. In the vacuum tubebusiness, which supplies electronic tubesfor old TVs, radios, and other equipment,Richardson Electronics is the survivor in anindustry once dominated by GE, RCA,Westinghouse, and Sylvania. Using an endgame strategy, the remaining producerscan extract large profits from customerssince they have nowhere else to go for theirreplacement parts.What are the key competitive factors withinthe industry?The basis of competition in each industry ormarket tends to be different. It has a major
  • 67. impact on how a business attacks itsmarket. There are five major keycompetitive factors that constitute thebattleground in most industries:- Quality- Price- Advertising- Research and Development- ServiceIn the fast food industry, for example,intensive advertising and promotion arekey. In industries providing raw materials toothers, price and service are key. In myinvestigation of the coffee industry, I foundprice and quality to be the basis ofcompetition. When developing a marketingplan, you may want to try to change thebasis of competition to one that favors yourfirm, but the key underlying competitive
  • 68. factors cannot be ignored.3. Analysis of Your Company Versus theCompetitionConsumer Market Competitive AnalysisDistribution Marketing Mix EconomicsReviseBy this stage the marketer has preliminarilychosen a consumer segment toward whichto direct his or her efforts. Now, a plan tobeat the competition must be developed.You need to look at yourself and at thecompetition with the same level ofobjectivity. What are your advantages?What things do you do well? (MBAs callthem core competencies.) What are yourweaknesses? How can your companycapitalize on its strengths or exploit yourcompetitors’ weaknesses? The following
  • 69. questions help to flush that out.What is your company good at and what isthe competition good at?- Distribution (Frito-Lay)- New Product Development and Introduction (3M)- Advertising (Absolut vodka)Who are we in the marketplace?- Market Size and Relative Market Share- Financial Position- Historic Performance and ReputationWhat are our resources versus those of thecompetition?- People- Technology, Research- Sales Forces- Cash
  • 70. - Trade Relations- ManufacturingBarriers to entry to new competitors in amarket play an important role in assessingthe competition. Barriers are conditions orhurdles that new competitors have toovercome before they can enter themarket. The availability of cash andspecialized knowledge are such barriers.The pharmaceutical industry, for example,is dominated by a few companies. To be aplayer, a company needs a large salesforce, research labs, and a large bankaccount to pay for it all. Because of thesebarriers, most small companies team upwith large ones if they have a promisingnew drug to peddle.If in an industry the barriers to entry arelow, the playing field becomes very
  • 71. crowded. Savvy marketers should plan forthat eventuality by trying to form amarketing strategy that new competitorscannot easily copy. This is more fullydiscussed later in the book in the Strategychapter.During my coffee investigation, I looked atwhat my company had to offer. It didn’thave much. It didn’t have any experience inthe United States. We lacked distribution,advertising expertise, a reputation, andcash. The only thing my Mexican employerhad to offer was quality packaged coffee.What could a small competitor do againstFolger’s and Maxwell House coffees? Aftermuch questioning, and feeling a little ill, Ihoped that there might be a large foodcompany that would like to enter into a jointventure. We would supply the coffee and
  • 72. the partner would do the distribution andmarketing. We could piggyback, not unlikewhat small pharmaceutical companies do,recognizing that some profit is better thannone.What are the market shares of the industryplayers?Many tracking services are available forconsumer products such as Selling AreasMarketing Inc. (SAMI) and A. C. Nielsen.Checkout scanners and warehousetracking collect supermarket sales data.However, for industrial products, such asmanufacturing equipment, the informationis less accessible. Trade associations are agood source.The shift of share over time is extremelyimportant. In the battle for “instant” coffeesales in the grocery store, for example, the
  • 73. top three competitors controlled 95 percentof the market in 1989, up 5 percent from1986. They were Kraft Foods (37 percent),Nestle (34 percent), and Procter & Gamble(24 percent). Little was left for a newentrant.Market share leverage is a key concept toconsider when examining market shareswithin an industry. The companies withlarger market shares relative to theircompetition usually enjoy higher profits.Larger competitors can produce morecheaply on a per-unit basis because theycan spread their costs over more units. Asmaller competitor cannot afford to spendas much on either research or moreefficient equipment, because the smallersales volume cannot support the burden. IfI had been charged with a new instant
  • 74. coffee to sell, I would have had toreconsider entry into the declining instant-coffee market dominated by bigger, lower-cost competitors. Fortunately for myMexican coffee’s entry, in 1989 18 percentof the “ground” coffee market wascontrolled by smaller competitors. And thatshare had increased from 16 percent in1986. This constituted a far more favorableenvironment for a new entrant such as myMexican ground coffee.How does my product perceptually mapagainst the competition?The perceptual mapping technique is agraphic way to view and compare yourproduct against the competitors’. Acommonly used grid is price and quality,but many others are possible and useful.Maps are another MBA technique to
  • 75. generate ideas for marketing for yourproduct, and perceptual maps mayhighlight an unserved market segment byshowing how the consumer perceivescompeting products, regardless of thephysical reality of performance.Perceptions are paramount in marketing,just as they are in politics. In the papertowel industry, for example, towel strengthand decorator appeal are very important.As an example, using my own judgment, Ihave created a “hypothetical” map on page23. Notice that Bounty found itself a veryprofitable market segment by providingstrength and a pretty pattern.By visualizing how your product mapsversus the competition, you may gain aninsight into how to market your existingproduct, make product changes, or add
  • 76. additional products in a comprehensivemarketing strategy.If your company has many products withina category, then you are said to have depthof line. In the paper towel market no oneproducer dominates the category. But overin the dog food aisle, Ralston’s depthchokes the shelves with Dog Chow, PuppyChow, HiPro, O.N.E., Lucky Dog, and atleast six other brands.If your company has many products in avariety of product classes, you are said tohave breadth of product line. Kimberly-Clark has a wide breadth of paper productsin several categories: Hi-Dri paper towels,Kleenex tissue, Kotex sanitary napkins, andHuggies and Pull-Ups diapers. Depth andbreadth of product lines can be cleverlyused in a blocking strategy to prevent
  • 77. competitors from gaining access to thechannels of distribution. If they are not onthe shelf, your competition can’t make anysales.Perceptual Mapping Paper Towel Brands (Hypothetical)
  • 78. In the dog food industry, competitors foundother ways around Ralston to reach doggieowners. Iams sold $350 million ofEukanuba brand premium dog food in 1996to breeders and specialty stores. In the
  • 79. same year Hill’s Pet Products, a division ofColgate-Palmolive, pushed $750 million ofScience Diet pet food and other productsthrough veterinarians’ offices.4. Review of the Distribution ChannelsConsumer Market CompetitionDistribution Analysis Marketing MixEconomics ReviseMarketers speak of the avenues to theconsumer as the channels of distribution.There are often many ways of reachingyour customers, as described with dog foodsales. Distribution channel analysis iscritical, because the choice of channelinfluences the price you can charge, and,consequently, the profit margins that youmay enjoy. Three questions should beasked to provide you with a basis for yourdistribution decision:
  • 80. How can my product reach the consumer?How much do the players in eachdistribution channel profit?Who holds the power in each distributionchannel available?How can my product reach the consumer?In the case of many mail-order catalogs,there is a direct link between the marketerand the final consumer. A catalogmanufacturer of clothing has a direct pulseon sales, returns, pricing, and consumertastes. As manufacturers of grocery items,brand managers are distanced from thebuyer. Cereal, for instance, must gothrough wholesalers and retailers beforereaching the consumer. Those middlemenare called channel intermediaries. As a
  • 81. strategist, the marketing manager mustoutline all the paths to the consumer todevelop a plan.Commonly used channel intermediaries tothe consumer are:- Wholesalers- Distributors- Sales Representatives- Sales Forces- RetailersHow do the players in each distributionchannel profit?As I mentioned, it is very helpful tounderstand all the paths to the consumer inorder to know all the possible ways tomarket your product. Take the time to drawthem out on paper. A channel sketch canalso give you the insight into the retail pricethat must be charged to make a profit.
  • 82. Everyone who touches the merchandisetakes a cut, which is called their margin.Participants in the distribution chain aresaid to “take margin” from themanufacturer. As a manufacturer of aproduct, you do not “give” the channelmargin; there is no charity involved.Channel participants in most industriescalculate their cut as a markup on sellingprice. Canadian and some U.S. drug firmsuse a markup on cost, but they are theexceptions. The selling price is not theultimate retail price, but the price at whichone intermediary sells goods to the nextintermediary in the chain. The retail price iswhat a consumer pays.Because of my experience in the coffeeindustry, I will use coffee retailing todemonstrate the economics of the channels
  • 83. of distribution. At each level of the chain,the intermediary buys the coffee from theprevious level and takes a margin based onthe sales price to the next level. The marginis not based on cost.This is how one dollar’s worth of coffeebeans, in my example, can reach theconsumer at a price of six dollars. At eachlevel, the channel participant adds valueand incurs costs by either roasting,grinding, and packaging the coffee beans;promoting the brand; or distributing andshelving the packaged coffee for theconsumer. I have outlined on page 27 whatI estimated were the channel economics in1989 for Maxwell House’s gourmet Private
  • 84. Collection coffee.At each level in the distribution channel, theparticipant performs its function, takes itsmargin, and sells to the next participantcloser to the consumer. If a coffeeprocessor, such as Kraft Foods, believesthat its gourmet Maxwell House PrivateCollection coffee brand must retail at $4.00per pound rather than $6.00, then theeconomics of the chain must change. Let’swork backward through the chain to see itseffect on the prices charged at each level.Selling Price × (1 Markup %) = ThePreceding Distribution Level’s Selling PriceWorking backward through the distributionchain:$4.00 Retail Price to Consumer × (1 .23Retail Markup) = $3.08
  • 85. $3.08 Wholesaler Price to Retailer × (1 .09Wholesale Markup) = $2.80$2.80 would be Kraft Foods’ (theProcessor’s) Price to WholesalersAt the $4.00 price, Kraft Foods’ brandmanager must ask if $1.75 ($2.80$1.05)per pound is a sufficient margin to covercosts and provide an adequate profit. If theanswer is no, the brand manager mustreexamine the marketing plan’s channelmathematics. Because marketing strategyis a circular process, another price,manufacturing process, or cost may haveto be altered. Such changes could affect allthe other elements of the plan.The relative power of the channelparticipants can dictate pricing decisionsbased on the economics of the channelchosen. In Kraft Foods’ case, the brand
  • 86. manager could have opted for the lower$4.00 retail price in the grocery store.However, he chose $6.00 to yield hisdesired profits.Kraft Foods decided to use an alternativechannel in addition to grocery stores. Kraft“bypassed” the grocery trade’s middlemenand sold its Gevalia and Garraway coffeebrands directly to coffee lovers by mailorder at a price over $8.00 per pound. Withmost products there are usually a variety ofways to reach the consumer. Each channelhas its own channel margin mathematics.By understanding the math you are betterable to make a choice of channel.Who has the power in the channels?The question of channel power is verycrucial in selecting where to sell. If yourproduct is unique and in demand, then the
  • 87. manufacturer generally has the power tooutline the terms of the relationship. If not,the channel’s intermediaries will be able todictate the terms to take as much marginas possible.Channel of Distribution for Maxwell House’sPrivate Collection Coffee with ChannelMargins and Prices
  • 88. In the grocery trade, the power of thechannel has shifted from the manufacturersto the supermarket chains. As smallergrocery chains consolidated into largersuper chains in the 1980s, the largerchains’ management realized that they heldthe prized real estate, “shelf space.” Eachstock keeping unit (SKU) on the shelf takesspace. Each product must be tracked,shelved, and inventoried. (When Mazolacooking oil produces three sizes, it takes upthree (SKUs.) With a finite amount of storeand warehouse space, the shelf real estatehas become valuable, and retailers want tobe paid for carrying each SKU. Marketerseven diagram their shelves like architects indrawings called planograms and fight overbest placement.
  • 89. Packaged goods companies, large andsmall, must often pay slotting fees to thechains to reserve their “slots” on theirshelves for both new and existing products.In the 1970s the packaged good giantscould force their products on the trade.When there were many smaller grocerychains, Procter & Gamble and Kraft Foodscould play one chain against another bythreatening to withhold their popularproducts. That is no longer the case.Unfortunately, slotting fees can run intomillions of dollars for a new productintroduction. Therefore, in practice, slottingfees bar smaller competitors from selling inthe supermarket. A maker of an excellentpizza in the Midwest that I knew failed toget off the ground because it could notafford the bribes necessary for space.
  • 90. Slotting fees are a “hot topic” in retailing.Feel free to interject this topic into MBAconversation as often as you like.5. Development of the Marketing MixConsumer Market CompetitionDistribution Plan the Marketing MixEconomics ReviseBased on judgments developed in theanalysis of the consumer, the market, thecompetition, and the distribution channels,the marketing manager must make a set oftangible decisions. MBAs call it the actionplan. Marketing managers choose what mixof marketing efforts should be made. Themix is commonly referred to as the Four P’s of marketing.The development of the marketing mix isan evolutionary process whose goal is an
  • 91. internally consistent and mutuallysupportive plan. That cannot beoveremphasized. Tinkering with one P inthe mix generally means the marketingstrategist must alter all the other P’s insome way, because one P affects theothers.The Marketing Mix
  • 92. Product Place Promotion PriceProduct Decisions
  • 93. How does my product fit with my otherproducts?How will I differentiate my product?How does the product life cycle affect myplans?How does the product fit with my existingproduct line?This question tries to identify areas ofsynergy among your products, or uncover aconstraint on your activities. For example, if“The Dependability People” at Maytagadded dishwashers to their line of clotheswashers and dryers, the product, thecustomers, and the retailers for thedishwashers would be shared with theirexisting line. There would be a fit with thisline extension. But if Maytag wanted to sellpersonal hair dryers, the fit would bequestionable.
  • 94. How will I differentiate my product?Differentiation is a broad issue that includesany way that a marketer can distinguish hisproduct from the field. Consequently thereare many ways to do it.- Feature—Capabilities- Fit—Tailoring- Styling—Functional, visual- Reliability—Warranties, return policies- Packaging—Color size, shape, protection- Sizes—Clothing, appliances, computers, and luggage sizes- Service—Timeliness, courtesy, accuracy- Brand Naming—LabelingIf Ralph Lauren had used his real name,Ralph Lifshitz, he would have foregone thepsychological benefits derived from hisRalph Lauren’s Polo label on $1.3 billion inclothing, cologne, and bedding in 1998.
  • 95. Lifshitz somehow fails to convey the imageof English aristocracy.In many cases the so-called brand equity ofone product can be transferred to newproducts using a brand or line extensionstrategy that differentiates it from the pack.Kraft Foods has chosen to place the Jell-Obrand name on its new pudding and icecream treats. The Jell-O brand bestowsupon the new products all the goodwill andbrand recognition (brand equity) that Jell-Oearned over decades. It would take manyyears of expensive advertising to establishthe brand equity of the Jell-O brand.Accordingly, almost 70 percent of thetwenty-four thousand new productintroductions since 1987 were line andbrand extensions. If stretched too far, abrand’s equity can be diluted and its
  • 96. effectiveness with consumers devalued.The choice of any one of these productdifferentiation techniques affects the entiremarketing process, as it lays thegroundwork for your promotional efforts. Aproduct can be differentiated from thecompetition by creative advertising andpromotion, even if competing products arephysically identical.Perceptual maps and positioning can helpto differentiate the product. All the productattributes mentioned affect the positioningof a product in the marketplace. Themarketer can always call upon hiscompany’s product engineers to develop aproduct’s physical characteristics if theprofits justify it. As my perceptual map ofpaper towels indicated, consumers havespecific needs within a product class and
  • 97. they perceive each product differently. Themarketer’s job is to uniquely position theproduct (using a perceptual map as a guideif desired) to earn its place in the market.That place is often called a product’s nichein the market. As pictured in the perceptualmapping of paper towels, James River’sBrawny brand is positioned as the tough,durable towel for really dirty cleanups.Hopefully the brand manager will choose aniche that will yield the most sales andprofits by targeting a market segment hisproduct serves best. Positioning isinexorably tied to the market segmentselected through your consumer andmarket analysis.How does the product life cycle affect myplans?
  • 98. Based on the point in the product life cycle(PLC), different aspects of the productbecome more important in the competitivebattles. The previous discussion of the PLCnoted that product features are extremelyimportant to differentiate products in thegrowth phase, while branding isincreasingly more important in the maturityphase. The emphasis on multiplay featureson compact disc players, for example,currently indicates the growth phase of thePLC. In the mature cassette deck market,the battles over auto reverse and Dolbynoise reduction have already been playedout. Whatever the choices for the product,product decisions will have a definite effecton the other P’s of the mix.
  • 99. ProductPlace Promotion PricePlace of Sale Decisions: Where to Sell?In your review of the distribution channels,the goal was to determine what avenuesexist and what margins are available. Atthis stage, having made product decisionsand a choice of target market, the marketerhas to choose an appropriate channel to fitwith the product and the intended buyers.What distribution strategy should I use?On what basis should I choose a channel ofdistribution?What type of distribution strategy should Iselect?- Exclusive—Sell in only one outlet in each market
  • 100. - Selective—Sell in only a few outlets in each market- Mass or Intensive—Sell in as many outlets as possibleThe place of sale affects the perception ofyour product. The choice of distribution isan evolving process that matches theproduct’s intended diffusion along theproduct life cycle, as described in themarket analysis passage. A distributionstrategy can differentiate your product fromthe crowd. For example, if a new designerchooses to sell exclusively at NeimanMarcus, it gives a certain cachet to theproduct. Consumers tend to perceivecertain attributes in a product, such asstyle, quality, and price, based on the pointof sale. The same designer may choose toselectively sell in only better department
  • 101. stores to provide greater initial salesvolume. The California marketer of carwindow sun shields had no such concern,and selected a mass distribution strategy.The company wanted to distribute thecardboard shade as widely and quickly aspossible. That choice made sense sincethe shades, unlike designer clothing, didnot have any status appeal and could beeasily copied and manufactured.Each of these distribution methods placescertain responsibilities upon themanufacturer and the retailer. By choosingto be selective, the manufacturer may be“obligated” to provide high quality, goodservice, and possibly cooperative payments(co-ops) for promotional support. Whenmanufacturers share the costs ofadvertising with retailers, that is called
  • 102. cooperative advertising.In distribution relationships involvingmanufacturers’ incentives, the retailer isalso obligated. Retailers may be “obliged”to pay special attention to the product bygiving it preferential placement, specialpromotion, display, and sales attention. Ifthose obligations are not met, the contractis breached and the relationship can besevered. In Ralph Lauren’s case hebelieved that his Polo clothing line was sounique that he became the first designer todemand separate boutique space indepartment stores. Ralph provided theimage and the margins sought by retailers.The retailers were in turn obliged to provideRalph Lauren with special placement andselling efforts.
  • 103. Which channels of distribution to choose?It depends…on a variety of factors. Thereis usually more than one choice. However,if a channel is integrated into a mutuallysupportive and internally consistentstrategy, many choices can potentially besuccessful. Three factors should serve as aguide to make a selection.Product Specifics. Another factor toconsider is the level of attention needed forthe sale. This is related to the level ofcomplexity of the product, the newness, orthe price. The product may indicate a needfor your own sales force despite the costs.On the other hand, products such as candyand soft drinks are sold through a series ofwholesalers and distributors beforereaching the store shelves. These productsare simple and do not require direct control
  • 104. by the manufacturer over the presentationand sale.Need for Control. The ability to motivate thechannels to carry your product effectivelyand appropriately enters into the placementdecision. The further the manufacturer isremoved from the consumer withdistributors, wholesalers, and jobbers, theless control the manufacturer has over howa product is sold. Pharmaceuticalcompanies usually have their own salesforces, also called captive sales forces, thatare thoroughly trained to provide credibleinformation to doctors. If Merck or Pfizerhad to rely on an independent sales forcethey would not have absolute control overtheir training or conduct in the field.Margins Desired. The analysis of thechannels of distribution helps to determine
  • 105. the potential profits available. Where arethe margins taken at each level? Can yourcompany deliver the product through thechannels at a competitive price and stillreserve enough margin for itself? Based onthe available margins, channel decisionscan be made. In the case of radardetectors, Cincinnati Microwave opted tosell directly to the public through magazinedisplay advertising. They chose not to sellthrough electronics stores or other generalmerchandisers. Their managementbelieved that the technological superiorityof their Escorts and Passports would helpthe units sell themselves. CincinnatiMicrowave chose to capture the entire retailmargin and to cut out all the middlemenwho typically distribute and sell electronics.Their strategy faltered because they failedto maintain their product’s technical edge.
  • 106. Product PlacePromotion PricePromotional DecisionsPromotion includes all the advertising andselling efforts of the marketing plan. Goalsetting is paramount in developing apromotional campaign. You need to knowthe mission you want to accomplish beforeyou can begin to draft or spend thepromotion budget. The ultimate goal ofpromotion is to affect buyer behavior;therefore the desired behavior must bedefined. Different products, at differentstages of the PLC, with different levels ofinvolvement and complexity, requiredifferent promotional efforts to performdifferent missions. The promotional missionchosen for your product must be consistentwith the buying process outlined in your
  • 107. consumer analysis.Buying ProcessPromotional MissionAwareness Inform about product, prompt aneed messageInterest Provide compellingmessage, solve a need messageTrialMotivate actionRepurchase Cue to buy,increase usageLoyalty Reinforce brand orimage, special promotionsPush or Pull Strategy? As with distribution,promotional efforts should be guided by astrategy. Pull strategies are those effortsthat pull buyers to the outlets that carryyour product. TV pitches that instructviewers “to ask for Perdue chicken byname at your local grocer” pull consumersto the stores that carry it. Another importantmission of promotion is to encourage the
  • 108. distribution channels to stock and sell aproduct to consumers. Such efforts are apush strategy. Beer distributors, forinstance, spend a great deal of their timetrying to court bar owners to stock andpromote their brew on tap. Most plans havean element of both push and pullstrategies. In the beer industry they spendheavily to advertise the brand as well as togain greater bar distribution.To pull buyers to a store or to push thedistribution channel to stock and sell, thereare five general categories of promotionalefforts:AdvertisingPersonal Selling
  • 109. Sales PromotionPublic Relations and PublicityDirect SellingAdvertising. Advertising takes many forms:television, radio, outdoor (billboards),magazine, and newspaper. Two importantthings to keep in mind are your intendedmission and the quantitative measurementof exposure required to accomplish it.Please pay attention to the followingmeasurement vocabulary. This is what youpay for when you buy advertising. Thetendency for the uninitiated is to listen tothe ad world’s babble, not understand it,and buy their wares anyway. Buyingadvertising is just like buying marketingresearch—know what and why you are
  • 110. buying—buyer beware.Reach and frequency are key quantitativemeasurements of media goals. Reach isthe percentage of the target market whosee and hear your promotion oradvertisement. Frequency is the number oftimes they saw or heard it. Marketers referto the number of times a person is exposedto a message as the total impressionsmade on that audience. Because of thebuying behavior associated with differentproducts, different mixes of reach andfrequency are required to induce purchase.When multiplied, Reach X Frequencyequals a measure called gross rating points(GRPs). Add the GRPs together and youget total rating points (TRPs). GRP andTRP are the measures by which radio, TV,and outdoor advertising is sold and
  • 111. purchased.The desired demographics andsegmentation variables of the audiencesdelivered also enter prominently into theequation. A TV station’s regional golfprogram that delivers active, middle-agedgolfing males with incomes over $100,000in the Southwest could be efficiently usedto advertise a variety of products. A TVprogram that attracts a muddled mix ofdemographic audiences is less valuableper audience member. Even if you have theright media vehicle, scheduling is key inreaching your target.High GRPs do not guarantee sales. Themessage delivered is also a keydeterminant. When advertising people referto the message, copy (wording), or layoutof advertising, they call it the creative, a
  • 112. noun. Ad agency people who develop theideas are called creatives.Magazine and newspaper advertising ispurchased based on the size andsegmentation variables of their circulations.Magazines have a longer shelf life, butnewspapers deliver a much moreimmediate and focused geographicreadership which is best for salepromotions. Both of these print audiencesare bought on a cost per thousand (CPM)readers basis. A comprehensive listing ofmedia and mailing list prices is provided bySRDS (Standard Rate & Data Service), in aseries of telephone book-sized volumes.A competitive measure of media is share ofvoice. Using this measure, an advertisercan target a certain percentage of mediaspending by all competitors within a
  • 113. product category. Advertisers believe thatto have an impact through the competitivemedia clutter and noise, the relativespending level is just as important as theabsolute dollars spent.Through the clutter, it would have beenfutile to run a TV ad to promote the tinycoffee brand that I managed during mysummer internship. A small competitor hadno chance against the likes of Procter &Gamble, Kraft Foods, and Nestlé, whotogether spent over $200 million inadvertising in 1999. Any affordable adwould have been drowned out by thegiants.Remember, each medium has its strengthsin reaching people. Some are moreselective than others. Marketers want toreach their intended targets as efficiently as
  • 114. possible to induce the desired buyingbehavior.Personal Selling. Marketers choosepersonal selling when they need to makedirect contact with the buyer. A salespersoncan personalize your message to fit thebuyer’s needs and situation, and can fieldobjections and questions in this interactiveprocess. This avenue is generally the mostexpensive element in any marketing mixbecause of the high cost of labor andcommissions paid.Managers of products that are new,complex, or expensive find that the benefitsof personal selling often outweigh their highcost. Because some target markets areinaccessible by other media vehicles,personal selling is sometimes the only
  • 115. means to reach consumers. Waterpurification systems, pharmaceuticals,encyclopedias, copiers, and industrialproducts widely utilize personal selling intheir marketing mixes.Current theory holds that personal selling isa problem-solving and consultationprocess. Professor Derek A. Newton of theDarden School at the University of Virginiasaw personal selling as having evolvedover the years in four stages: Music Man,Animated Catalog, Magic Formula, andProblem Solver. Before World War I it wasbelieved that the “Music Man” approach toselling was the key to success. It was thesalesperson’s personality that enabled himto charm his customer into buying. AfterWorld War I, the “Animated Catalog” wasconsidered the right way to sell. Vacuum
  • 116. cleaner salespeople knew all the factsabout their products, and their salespresentations were rehearsed catalogreadings. During the 1930s the slick pitchor “magic formula” was thought to be thebest sales approach. Encyclopedia salesreps would control the presentation andlead the customer down a “mapped-outroad” to a “sure sale.” Many books currentlyon the bookstore shelves claim they holdthe “secret” of how to close a sale. Today,academics agree that personal selling stillrequires some element of pizzazz andcataloglike product knowledge, but salesforces must also have extensive knowledgeof the prospect’s needs and buyingprocesses to be successful. Salespeopleshould sell benefits that solve customers’problems, rather than simply peddlingproducts.
  • 117. Sales Promotion. Sales promotion isdesigned to elicit the desired behavior fromthe consumer, the sales force, and otherchannel participants. Sales promotions aredesigned to complement and reinforceother promotional efforts, especiallyadvertising. Each type of promotion has itsown associated vocabulary that you shouldbe aware of. If you are not a marketer,knowing the vocabulary does not make youan expert, but it can sure help you toengage in intelligent marketingconversation, if need be. There are twotypes of promotions: those directed towardthe consumer, and those directed at thedistribution channels.Consumer sales promotions techniquesavailable are coupons, refund offers,
  • 118. samples, premiums, and contests.Coupons are a direct way to pass a pricereduction on to consumers. As amanufacturer, if you give retailers adiscount in hopes that they will pass italong to consumers, you may be sadlydisappointed. Marketers use coupons toencourage trial, brand switching, and brandloyalty. Grocery coupons are most oftenplaced in a special coupon section of theSunday paper called freestanding inserts(FSI). The leader in FSIs is ValassisInserts, which prints almost half of the $100billion in face value of coupon savingsdistributed annually in Sunday FSIs.Refunds are generally used to acceleratethe normal consumer purchase cycles.Refunds are usually used to increase thequantity or frequency of purchase by
  • 119. encouraging buyers to stock up. Batterymanufacturers frequently use refund offers.Such offers have been cleverly used tostock up consumers just before acompetitor’s promotion or productintroduction.Samples are a high-cost way of introducinga new product. Sampling requires a cashinvestment to produce and stock thesmaller-sized packages. Samples areproperly used for products whose benefitsare “sensory in nature” and cannot becommunicated effectively by advertising.Sampling may also be effective forproducts that consumers would view asrisky in switching to a new brand, or thatmay have a high probability of generatingword of mouth (WOM) activity after use.Many new shampoos use free or low-cost
  • 120. samples since their benefits are sensory.Consumers are reluctant to risk four dollarsto try a whole bottle. Sampling reduces thebuyer’s risk of trial.Premiums are items offered at low or nocost to purchasers of a product. Self-liquidating premiums are those for whichthe price charged covers just costs.Hershey has periodically offered watchesand Christmas ornaments as premiums. Toget the goodies, chocolate lovers have tosend in wrappers as proof of purchase. Mr.Bubble, the happy pink bubble-bath man, ispictured on inexpensive T-shirts, beachtowels, and sweatshirts that are printed onevery box.Contests and sweepstakes are a popularpromotion and the most restricted legally,because they border on gambling. A very
  • 121. thorough analysis of the game rules andthe laws must be conducted to avoid adisaster. State gambling laws must beinvestigated to ensure compliance. Thegame rules and odds of winning must alsobe scrutinized to ensure that thepromotional budget will cover theforecasted costs. In 1984 McDonald’s ran asummer Olympics medal game. Every timethe United States won, game pieces couldbe redeemed for free food and other prizes.When the Communist bloc boycotted thegames, the United States won most of themedals, and most of the game piecesbecame winners.Trade-directed sales promotions toolsinclude sales contests, point-of-purchasedisplays, dealer incentives, trade shows,and in-store demonstrations.
  • 122. There are many variations on the point-of-purchase display (POP). To get them in thestores requires the cooperation of thetrade. On the retail shelf a POP can be ashelf talker, a mini-billboard attached to theend of the shelf with a little ad used toattract attention. Freestanding aisledisplays and built-in shelf displays are otherforms of POP. When a display is at the endof an aisle it is referred to as an end cap.To get those prime spots, the manufacturermust entice the retailer. A marketer can doit by providing a high markup per item or ahigh turnover on lower-margin items.Dealer and employee incentives: Paymentsmade to dealers for marketing support arecalled spiffs. They can take the form ofslotting fees, case discounts, cashpayments, free merchandise, or prizes.
  • 123. Spiffs enable the dealer to discount,promote, or justify carrying a product. Amanufacturer can also give incentives tothe dealer’s employees to place storedisplays or award prizes for meeting salestargets.Trade shows are a way to promote a newor existing product to the wholesalers,dealers, retailers, and distributors. Thispromotion tries to encourage the channelparticipants to carry your product. Afledgling start-up company makinghousewares, for example, would need toattend trade shows to develop thedistribution contacts that might carry theirproducts to retail. If you have no tradecontacts, you have to develop them.In-store demonstrations: Trained expertsfrom the manufacturer are extensively used
  • 124. to promote products that otherwise wouldnot generate consumer interest or beaccepted by the trade. Small kitchengadget hucksters set up demonstrationplatforms to bring inconspicuous blades tolife by creating “beautiful” plate garnisheswith ordinary vegetables. The Cliniqueladies in their white smocks perform asimilar mission for their boxes of “natural”beauty at the cosmetics counter.Whatever the sales promotion you maychoose in a marketing mix, each elementmust have an explicit marketing mission tojustify its cost in the marketing mix.Public Relations and Publicity. Publicrelations (PR) is typically a promotional toolused to communicate to a broaderaudience. PR is intended to create a
  • 125. favorable climate for your product, not todirectly sell it. The list of possible PRtargets can include politicians as well asthe communities in which a companyoperates. The PR message can beintended to create goodwill, correct amistaken impression or factual situation, orto explain a firm’s actions. Sponsorship ofprestigious or charitable events or causesis often used to create a halo effect ofpositive feeling toward a corporation and itsproducts. Hallmark Cards’ sponsorship oftelevision’s Hallmark Hall of Fame aligneditself and its products with the attributes ofquality, culture, and good citizenship.Because the goals of PR are less definedthan a sales target, the results are moredifficult to measure. Opinion polls andlegislative victories are often used to
  • 126. measure PR success.Publicity, a form of public relations, is anyunpaid form of mass media communicationabout a company or product. It can take theform of a news story or even theappearance of a product in the media.Publicity is a two-edged sword. It is judgedas more credible by the public because it isnot purchased; however, there is lesscontrol over the message. Pressconferences, press releases, use bycelebrities, and staged events are used tocapture the media’s attention. Using a PRagency allows you to tap into their mediacontacts to capture an audience andhopefully control the impression madeabout your company or products.When tennis star Pete Sampras or AndreAgassi wears Nike shoes and sportswear
  • 127. at the U.S. Open, the TV can’t help butflash Nike on the screen each time heserves and volleys. This network time hasgreat value. If the athlete makes thenational evening news or Sports Illustrated, which cost $50,000 per thirty seconds and$150,000 per page, respectively, the valueof free media exposure can be great.Accordingly PR executives track theireffectiveness by measuring the value of themedia time or space captured. Trackingservices, such as Burrelle’s press clippingservice for print, report on their clients’ PRand advertising media exposure across thecountry. Burrelle’s can also trackcompetitors in the same way. Although it isoften overlooked in the marketing mix,publicity can often create a tremendousimpact if skillfully and creatively
  • 128. orchestrated.Direct Sales. Direct sales includes therealm of the Internet, junk mail, catalogs,shopping networks, and long-format TVinfomercials. Direct sales are big business.Internet sales exceeded $15 billion in 1999
  • 129. and are growing rapidly. In 1998 mail ordersales alone constituted $465 billion in salesor 6 percent of all retail sales. Over 8,000firms mailed out 12 billion catalogs thatyear and the numbers are still growing. In1999 the leading home shopping network,QVC Network Inc., had over $2 billion insales. Infomercial companies racked upover $400 million in revenues.The nature of the direct mail game is tosegment, segment, segment. Mailers targettheir market with a focused mailing list todirectly reach those households with acompelling mail piece. Lists can bedeveloped internally or purchased fromvendors listed in SRDS’s Direct Mail ListRates and Data directory. The moredefined, affluent, and focused the list is ona desired demographic composition, the
  • 130. higher cost per thousand (CPM) names.The results are tracked by rate of return(ROR) and dollar amount per order.Because TV audiences lack a list’sselectivity, TV sales pitches cannot be asdirectly targeted as direct mail.The other component of both direct mailand TV selling is fulfillment. Fulfillment isthe process of order entry, orderprocessing, inventory management,mailing, and customer service. The dreamsof those viewers of the Home ShoppingNetwork who want to buy porcelainfigurines must be fulfilled. The operationmay be executed internally orsubcontracted out to a fulfillment house thatperforms the duty for a per-order fee overcertain volume minimums. It saves smallercompanies the initial investment required to
  • 131. establish in-house fulfillment capabilities.Because direct selling is becoming such alarge part of the economy, it should not beignored as a possible channel to theconsumer. A thorny issue connected withthis selling method is the backlash againstthe “big brother” effect of having verypersonal information captured in mailinglists that churn out personalized pitches.This topic, like slotting fees, is a “hot” onefor MBA chatter.Each method of promotion—advertising,personal selling, sales promotions, publicrelations, and direct selling—canaccomplish a separate mission dependingon the product, the place of sale, and theprice. The gifted marketer goes to his orher palette of promotional options andcombines them in a coordinated
  • 132. promotional strategy to sell the productefficiently.Product Place PromotionPricePricing Decisions: What Should My PriceBe?The pricing decision, like the productdecisions, can dramatically affect themarketing mix by suggesting a channel ofdistribution or an advertising strategy. Thepricing itself can differentiate your productfrom the competition. Both the Yugo andthe Rolls-Royce are differentiated atopposite ends of the automobile spectrum.There are many rationales behind pricingeach product and service. Haven’t youseen a pair of Nike cross-trainers for sale at$59.95 instead of $60 for somepsychological advantage? Besides
  • 133. psychological pricing, there are eight majorpricing methods and strategies suggestedby research and case analyses.Cost Plus. This is a simple method oftaking your cost and adding a desired profitmargin. Highway contractors often use thissimple method; however, it is not theproper way to price.Perceived Value to the Consumer. You cancharge the customer the value provided,regardless of its cost. Replacement partsare a prime example—exorbitant prices arecharged for a cheap but crucial custom nutor bolt. The owner of a fixture manufacturerconfided to a group of my classmatesduring a school-sponsored plant visit thatthe majority of his company’s profits were
  • 134. derived from the twenty-by-twenty-footreplacement-parts cage, not from the longassembly lines producing the fixtures. If theprice charged for an item is commensuratewith the benefits provided, then it will beconsidered a good value in the mind of thebuyer. But remember, there are limits evenin a monopolistic situation.Skimming. Early in the introduction phaseof the PLC, a company can opt to charge ahigh price and skim high margins from anew and novel product or service. Themargins could be used to further R&D, as isdone in high-tech industries, or toimmediately reward the owners for fadproduct introductions. RCA used thisstrategy to charge high prices for color TVswhen they were introduced in the 1960s.
  • 135. Penetration. This pricing can be used in theintroductory phase or later in the PLC. Apenetration strategy would use a low priceto gain market share; the goal is primarilyto lower costs per unit by producing manyunits in hopes of eventually controlling amarket as the low-cost producer. Thespecifics of this strategy are discussed laterin the Strategy chapter’s discussion ofJapanese VCR production.The Price/Quality Relationship. Becauseconsumer perceptions are not necessarilybased on just the physical attributes of aproduct, the “perceived” quality is ofteninfluenced by its price. Apparel, perfume,and jewelry are examples where the priceitself affects the perception of product
  • 136. attributes. Consumers often attribute thecharacteristics of style and workmanship toa product just because of the high pricecharged.Meet Competition. Strategies frequentlydecide to match or beat competitors’ pricesto gain or retain market share in acompetitive market. This is especially thecase in commodity products and servicessuch as gasoline, steel, and airline tickets.The economics of pushing a productthrough the distribution chain, as explainedin the discussion of distribution channels,has a great effect on what price amanufacturer can charge to sell his productto the distribution chain and still end up witha competitive retail price.
  • 137. Meet Profit Goals Based on the Size of theMarket. If a market is limited in size, then aprice must be charged that will allowenough profit to justify the marketing andmanufacturing effort. If the product cannotcommand a profitable price, then to lowercosts investigate either other user marketsor manufacturing improvements.Price Based on the Price Elasticity of theBuyer. Price elasticity describes how abuyer’s behavior changes due to a changein price. Buyers with elastic demand do notreadily accept price hikes. Their demand isgreater or smaller depending on the price.Buyers with inelastic demand behaviorsdon’t care about price increases. Theydon’t decrease their quantity or frequency
  • 138. of purchase depending on the price.Tobacco and crack cocaine smokers, forexample, have absorbed many priceincreases and continue to buy becausetheir addiction makes their demandinelastic to pressure to accept priceincreases. If elastic, buyers will not paymore than a given price point and will stopbuying or buy much less based on theintensity of their desires, their personaldisposable income, or their psychologicalprice thresholds. Former New York Citymayor Edward Koch proposed in the 1980sthat the bridge tolls onto Manhattan Islandbe raised to ten dollars to reduce the city’sgridlock traffic conditions. He believed thatthe majority of the driving public’s demandwould be elastic to such a price increase.
  • 139. There are many avenues that may be takenwith any given product. In the case of mygourmet packaged coffee, a distinctivecoffee “product” may require a distinctivepackage, a higher “price,” a targetedpromotion, and a selective “place” fordistribution. But what really tells the story isthe economics. Can I do it and makemoney?6. What Are the Economics of My Plan?Consumer Market CompetitionDistribution Marketing Mix Determine theEconomics ReviseThis may be the last step of marketinganalysis. This step may also send themarketing manager directly back to Gowithout collecting two hundred dollars. Bythat I mean that the consumer analysis maybe exemplary, the marketing mix masterful,
  • 140. but it just doesn’t make money. The costsmay be too high, the market price too low.Perhaps unrealistically high sales volumemay be needed to break even. In those sadcases the entire circular process ofmarketing strategy must be restarted in aneffort to find a profitable solution. Todetermine whether you have created a planthat is both profitable and reasonable youmust address several issues.What are the costs?What is the break even?How long is the payback of my investment?What are my costs? Fixed or variable?The first cost question for a marketingmanager should be, “Which of my costs arevariable and which are fixed?” If this
  • 141. sounds like accounting, it is.Variable costs are those that vary with thevolume of products sold or manufactured.The costs of materials and labor arevariable costs. As more units are sold ormanufactured, the total costs of materialand labor are higher. Fixed costs do notvary with volume even if no sales aremade. As volume fluctuates neither rent norsupervisor salaries change—within arelevant range. By that I mean that if salestriple, a new factory may have to be leased,and thus fixed costs will go up. Promotionalexpenses such as advertising are alsoseen as a fixed cost of a marketing plan,because if the product is a flop theadvertising dollars are already spent. Theyare considered sunk costs—after a TV adairs, the dollars are “sunk” in the ocean of
  • 142. TV land. Total costs are a combination ofboth variable and fixed costs.Total Costs = Variable Costs Per Unit (VC)× Units Sold + Fixed Costs (FC)They can also be shown graphically asfollows:Wooden End Table Production
  • 143. Fixed Costs + Variable Costs = Total Costs
  • 144. What can be seen in the graphs is thatregardless of unit volume, the fixed costsremain constant. When units are actuallyproduced, variable costs are added on topof the fixed costs to equal total costs.What is my break even and is itreasonable?Break even is the point at which the fixedcosts are recovered from the sale of goodsbut no profit is made. Promotion andmanufacturing are very expensive. A waymust be found to recoup thoseinvestments. That’s the whole point ofmarketing: to recover costs and makeprofits.
  • 145. (Unit Contribution = Your Selling PriceVariable Costs)Using my data from the coffee industry, Ihave provided an example from the realworld. I determined that the prices andcosts of a proposed marketing plan for theMexican gourmet coffee were:CostCost Type Retail Sales Price $6.00 lb.Selling Price to Distributors 4.20 lb. CoffeeBeans Cost 1.00 lb. Variable Roasting andProcessing Cost .44 lb Variable PackagingCost .55 lb. Variable Shipping Cost .25 lb.Variable Spiffs and Slotting Fees 50,000Fixed Production Equipment Rental 12,000Fixed Promotional Efforts 150,000 Fixed
  • 146. The corresponding break-even volume wascalculated:And the break-even dollar sales were:108,163 lbs. × $6.00 lb. = $648,978 break-even retail salesThe same equation can be used tocalculate a target volume to yield a desiredprofit.
  • 147. To return a $30,000 profit target, you justadd the profit to the numerator with thefixed costs.One very important aspect of this analysisis that it does not include the costs thatwere “sunk” in the development of theproduct or the ad campaign if they havealready been spent. The evaluation of theeconomics is always performed from theperspective of the present. There shouldnot be any crying over spilled milk. Youneed to decide if you can make money on
  • 148. the proposed marketing spending in thefuture. For example, if the coffee blend wasthe product of millions of dollars ofresearch, that would be irrelevant to thedecision to whether I should spendadditional money to market it. If I includethe millions of research, it would be adefinite “no go.” However, with that moneydown the drain, it might be profitable toinvest additional cash in a marketing effort.The graphical representation of themarketing plan economics for the Mexicancoffee looked like this:Gourmet Coffee Marketing Plan Economics
  • 149. Is my break even reasonable in relation tomy relevant market? Answering thisquestion must be your next step. In thecoffee example, $648,978 of break-evenretail sales was a .26 percent share of the$248 million market for gourmet,nonflavored coffee sold through thesupermarket channel as explained earlier in
  • 150. the chapter. The targeted retail sales of$740,814 equaled only a .3 percent shareof the relevant market. On that level, theplan appeared reasonable if I believed$150,000 of promotion and $50,000 ofdealer incentives could have produced$740,814 in sales. Imagine that—I couldhave reached my goal with only a .3percent share of the market!Unfortunately, a small target share caneasily lead you to believe that it is easy toobtain. How fierce was the fight for thegrocers’ shelf? If my coffee got on the shelf,somebody else’s had to be kicked off. Howwould they react? Once in the supermarket,would my company have been willing tocontinue to support the coffee when acompetitor went after my shelf space? Inmy case, the company was not willing yet
  • 151. to make that kind of long-term commitmentto coffee.What is the payback period on myinvestment?This is another hurdle frequently used bycompanies to evaluate marketing projectswhen they have many to choose from.Companies want to know how long it willtake just to get their investment back.Forget about profit. The payback formula is:In the coffee example, the calculationwould be:
  • 152. If the yearly profit is not the same eachyear, there is no formula. The break-evenpoint is where the plan returns the initialinvestment.Seven years is a bit long for a riskyventure. This may indicate that the wholemarketing development process shouldstart again. And unfortunately for me it did.7. Go Back and Revise the PlanConsumer Market CompetitionDistribution Marketing Mix EconomicsRevise the PlanAt this stage of disappointment, I revisitedthe marketing strategy developmentprocess outlined at the beginning of thischapter. In circumstances such as those Ifaced, you must either tweak or discardyour plans entirely. You may have
  • 153. something that can be salvaged…if you’relucky. You have to start by asking yourselftough questions. In the case of the coffeeproject I tormented myself with:Should I target another segment?Is the mail order distribution channel anoption?Should I not advertise and rely on a cheapprice to move my product?As these questions indicate, the marketingprocess is not easily defined or executed. Itcan be frustrating because there are no“right” answers. Consumer reactionscannot be easily predicted. It takescreativity, experience, skill, and intuition todevelop a plan that makes sense and
  • 154. works together (internally consistent andmutually supportive). Marketing alsorequires close attention to the numbers tobe successful. With this chapter you arearmed with the MBA problem-solvingstructure and the MBA vocabulary to attackthe marketing challenges that you mayencounter. You haven’t even paid a dollarin tuition, sat through a class, or anted upfor an expensive executive seminar. Figurethe break even on that investment!I include the following notes that we allpassed among ourselves at school to guideour case discussions and tests (opennotes). These are the key questions thatmust be addressed by a comprehensivemarketing strategy.
  • 155. Marketing Strategy Outline1.Consumer Analysis- Makable or marketable product?- Who’s buying, who’s using?- What is the buying process?- Who are the “Influencers”?- How important is it to the consumer?- Who needs it and why?- What is the value to the end user?- Is it a planned or impulse buy?- What are the perceptions of our product?- Does it meet their needs?
  • 156. Market Analysis- What is the market’s nature? Size, growth, segments, geography, PLC- Competitive factors? Quality, price, advertising, R&D, service- What are the trends?Competitive Analysis- What is your company good at? Poor at?- What is your position in the market? Size, share, reputation, historical performance- What are your resources? Trade relations, sales force, cash, technology, patents,
  • 157. R&D- Who is gaining or losing share?- What do they do well?- Compare your resources to theirs.- What are the barriers to entry?- What are your objectives and strategy?- Any contingency plans?- Short-and long-term plans and goals?Marketing Mix- Who is the target?- Product—Fit with other products? Differentiation, PLC, perception, packaging,
  • 158. features- Place—How best to reach segment, channel mathematics, draw channels.- Exclusive, selective, intensive distribution? Fit with product?- Who has the power?- How to motivate the channels?- Promotion—What is the buying process? How are $’s targeted to buying-process goals?- Push or pull strategy?- Media—type, measure, message
  • 159. - Dealer incentives- Consumer promos—coupons, contests- Price—What strategy? Skim, penetrate?- Seek volume or profits?- Perceived value, cost-plus pricing?- How does price relate to the market, size, product life cycle, competition?Evaluate the Economics- Break even in units- Fixed Cost/(Selling—Variable Cost) Include fixed marketing and promo costs in fixed costs of the plan!
  • 160. - Relate break even to relevant market- What is the payback period? Exclude sunk costs!- Are goals reasonable? attainable? Key Marketing TakeawaysThe 7 Steps of Market StrategyDevelopment:1.Consumer analysis2.Market analysis3.Competitive analysis4.Distribution channel analysis5.Develop the marketing mix6.Determine the economics7.ReviseNeed Categories—All the possible uses ofa product or service
  • 161. The Buying Process—The stages ofmaking a purchaseProduct Involvement—The importance of aproduct to the consumerSegmentation Variables—Ways to dividethe population to find a profitable targetRelevant Market—The portion of themarket that is interested in your productProduct Life Cycle—The birth-to-death (andpossibly rebirth) life cycle of a productPerceptual Mapping—A multivariablepicture of a product and its competitorsChannel Margin Mathematics—Each levelin the distribution takes a margin of theselling price it charges to the next level ofdistribution.The Marketing Mix of the 4 P’s—Product,place, promotion, and price
  • 162. Distribution Strategies—Exclusive,selective, and mass marketChannel Power—Who in the distributionchain dictates the terms of the relationshipsAdvertising Measures—Reach, frequency,GRP, TRP, share of voice. Buy wisely.Pricing Strategies—Cost plus, penetration,value pricing, skimmingBreak Evens—The volume of sales neededto recover the fixed cost of marketing plan Day 2 Ethics Ethics Topics
  • 163. RelativismStakeholder AnalysisUnlike most topics in the MBA curriculum,which have remained fairly consistent fordecades, ethics is a new area in the MBAprogram. What appeared at first to be onlya trendy elective course has now becomeinstitutionalized as part of the core MBAcurriculum at Harvard, Wharton, andDarden. With the criminal convictions ofinsider traders in the 1980s, businessschools took notice and jumped on theethics bandwagon in the 1990s.Ethical dilemmas make for a livelyclassroom discussion. It was revealing tosee my fellow students deal withcontroversial topics. My “politically astute”classmates would play it safe and take the
  • 164. ethical high ground before teachers andpeers. My more insecure classmates wouldnot participate at all. Others would expressjust what they thought, no matter howpolitically “incorrect” it may have sounded. Ifell into this last group. But I must admit, Itook many unpopular positions just to livenup the class discussion. In any case, ethicsis a good topic for speaker forums andgreat fodder for articles and dissertations.Since ethical problems often have nodefinitive answers, the area will remainfertile academic ground for years to come.The purpose of ethics in the MBAcurriculum is not to make students modelcorporate citizens. Rather, the intention isto make students aware of the ethicalimplications of business decisions. Throughcasework and role playing, students
  • 165. confront ethical dilemmas similar to thosethey will face in the workplace.The top business schools train their futurechampions of industry to deal with anychallenge. You name the “hot” topic, wethrashed the issue out in class:
  • 166. Environmental issues—pollution, toxicwaste dumping, animal rightsCorporate restructuring—layoffsEmployee privacy issues—AIDS, drugtesting“Diversity” issues—race, ethnicity, gender,and sexual orientationSexual harassmentConduct of multinational corporations(MNCs)—briberyOther—antitrust actions, predatory pricing,insider trading The Social Responsibility of Business
  • 167. Talk about ethics rests on the assumptionthat businesses ought to adhere to asocially responsible approach to decisionmaking called the social responsibilityapproach. Proponents of this approachbelieve that corporations have societalobligations that go beyond maximizingprofits. Business schools encouragestudents to adopt this “politically correct”philosophy. It is argued that becausecorporations are so powerful, they have anobligation to assume social responsibilities.Corporations should be managed for thebenefit of their stakeholders: theircustomers, suppliers, employees, and localcommunities, as well as their owners.Corporate leaders bear a fiduciaryresponsibility to all stakeholders.
  • 168. Flying in the face of the “politically correct”philosophy espoused at most institutions isa competing school of thought led by MiltonFriedman of the University of Chicago.Friedman believes that business’s sole dutyis to make profits. “Businesses are in thebusiness of maximizing shareholders’ valueby a prudent use of scarce organizationalresources, as long as the activities of thebusiness are within the letter of the law.” InFriedman’s view, it is up to government todetermine what the laws should be. Aprofitable business benefits society bycreating jobs, increasing the standard ofliving of its owners and its employees.Corporations pay the taxes that supportgovernment’s social action. AlthoughFriedman is exalted as one of thedefenders of capitalism in economicscourses, my school tended to discourage
  • 169. his views when it came to ethics class.There are two major topics taught in theethics curriculum: relativism andstakeholder analysis. Relativism examineswhy we often ignore ethics in our decisionmaking, while stakeholder analysisprovides a structure with which to confrontethical decisions. RelativismThe proponents of relativism hold that wecan’t decide on matters of right and wrong,or good and evil. Things are rarely black orwhite. There are so many shades of gray.Relativism proposes that ethics are“relative” to the personal, social, andcultural circumstance in which one findsoneself. Relativists are not torn by ethicaldilemmas since they do not believe thattruth can be discovered through soul
  • 170. searching. Professors teach relativism sothat students may guard against it. Tounderstand relativism, you need torecognize its four forms:Naïve RelativismRole RelativismSocial Group RelativismCultural RelativismNaïve relativism holds that every personhas his or her own standard that enableshim or her to make choices. No one canmake a moral judgment about anotherperson’s behavior. So many variablesaffect behavior that an outsider cannotpossibly be privy to all the elements thatwent into making a decision. Therefore, an
  • 171. executive at Borden is not equipped tomake a moral judgment regarding theactions of the chief executive officer (CEO)of Nestlé, whose corporation is possiblyselling harmful baby formula in developingcountries.Role relativism distinguishes between ourprivate selves and our public roles. Thesepublic roles call for a “special” moralitywhich we separate from the individualmaking the choices. The president of afishing company may personally dislike theincidental killing of dolphins in hiscompany’s tuna nets, but as an executive,he must not let his feelings interfere withthe best interests of the company.Social relativism is akin to naïve relativism.People refer to social norms to renderethical judgments. “Industry practices,”
  • 172. “club rules,” “professional codes ofconduct,” and “accepted practices” are thecop-outs of the social relativist. In theproduce industry, it is “industry practice” toignore child labor laws and employ smallchildren to work in the field and missschool.Cultural relativism holds that there is nouniversal moral code by which to judgeanother society’s moral and ethicalstandards. If a whole culture holds certainbeliefs, how can an outsider sit injudgment? “When in Rome…” The conceptof cultural relativism becomes moreimportant as companies compete globally.Multinational corporations often follow locallaws and customs that may violate ethicalstandards in their home countries.Discussions about apartheid revolve
  • 173. around issues of cultural relativism.Adopting a cultural relativist philosophy, amultinational corporation might havejustified its participation in South Africangold and diamond mining activities despitethe employment of “slave” labor in themines.In some instances U.S. corporations andcitizens are barred from adopting the hostcountry’s business practices. In somecountries it is ordinary business practice topay bribes to get favorable treatment frombusinesses and government. The ForeignCorrupt Practices Act of 1977 outlawsoverseas bribery.The relativism concepts provide MBAs withan awareness of and a way to guardagainst inaction on ethical and moralissues. They provide a framework to go
  • 174. beyond currently held beliefs and patternsof behaviors. These concepts are alsogreat conversational ammunition whenMBAs get together on social occasions.Other Ethical Frameworks. Relativism isnot the only philosophical framework withwhich to approach ethical decisions. Thereis also natural law, utilitarianism, anduniversalism. Natural law serves as a guideto some who believe that the “right” thing todo is revealed in nature or the Bible.Utilitarianism holds that an action is justifiedif it provides the greatest benefit for thegreatest number of people. Finally,universalism propounds that any action iscondonable if the motive behind the actionis good, since the results of a person’sactions are so often not in his or hercontrol.
  • 175. Stakeholder AnalysisAlthough there are no magic formulas forsolving ethical dilemmas, it is helpful tohave a framework with which to organizeyour thoughts. Stakeholder analysisprovides you with the tools for weighingvarious elements and reaching a decision.As a first step a list should be made of allpotentially affected parties, then anevaluation of all the harms and benefits thata particular action will have on thoseinvolved. The next level of analysis ought todetermine each of the affected parties’rights and responsibilities. Employees, forinstance, have the right to a fair wage andsafe working conditions, but they also havethe responsibility to be productive for thecompany. In a typical stakeholder analysisthe list of potentially affected parties might
  • 176. look like this:The Decision MakerExecutives, board of directorsCustomers—and the industry in which theyoperateShareholders, bondholdersSuppliers—and their industryEmployees—and their familiesGovernment—federal, state, and local andtheir agenciesSpecial Interest Groups—industrial,consumer, environmental, political, unionsThe Affected CommunityThe Environment—plants, animals, naturalresources
  • 177. Future Generations (an MBA favorite)CompetitorsLawyers and the CourtsObviously, the list could be much longer. Atthe analysis stage the list is narrowed tothe significant players, then a situationalanalysis is performed, and eventually adecision is reached. In order, these are thesteps:1.Get the main cast of characters.2.Determine the harms and benefits to each player.3.Determine their rights and responsibilities.4.Consider the relative power of each.5.Consider the short- and long-term consequences of your decision
  • 178. alternatives.6.Formulate contingency plans for alternate scenarios.7.Make a judgment.If you are interested in walking through thesteps outlined above, take out a recentcopy of Time or Newsweek and pick a topicwith an ethical aspect. With a piece ofpaper, jot down the main characters alongthe top, then along the side, place thewords “Harms and Benefits” first, andbelow that “Rights and Responsibilities.”Now you have the framework with which toattack the moral dilemmas of theday—MBA style.As an example, you might choose thedebate regarding the need to preserve thehabitat of the spotted owl by reducinglogging on federal lands. The stakeholder
  • 179. analysis grid would look like this:Spotted Owl Issue in a StakeholderFramework
  • 180. You may disagree with the way in which Ihave framed this issue, but with ethicsthere is no “right” way. People canapproach a situation differently and feelother stakeholders need to be represented.In this situation, at the very least, a timberCompany executive ought to consider thestakeholder before clear-cutting the owl’swoods. With the tools of stakeholderanalysis an MBA can tackle the issue ofendangered owls as well as other ethicalissues and make thoughtful and informeddecisions. Key Ethics TakeawaysSocial Responsibility of Business—Concept that businesses are accountableto more than their ownersRelativism and Its Four Forms—Reasonsto avoid making ethical decisions
  • 181. Stakeholder Analysis—A frameworkconsidering who is affected by a businessdecision Day 3 Accounting Accounting TopicsAccounting RulesAccounting ConceptsThe Financial StatementsRatio AnalysisManagerial AccountingAccounting is the language of business.Corporations need to communicate theirresults to the world. Their audience
  • 182. includes employees, investors, creditors,customers, suppliers, and communities.Within the company, accountinginformation provides a means to control,evaluate, and plan operations. Whateverthe audience or function, accounting isnumbers. Accountants (account-ants)“count the beans” so that business activitycan be recorded, summarized, andanalyzed. Accountants have been aroundfrom the beginning of time and professorsdon’t let you forget it.In biblical times the accountants kept trackof how much grain was stored in thecommunity’s silos. How do you think KingSolomon knew that there was only a thirty-day supply of grain during a drought? Itwas from the accountants. Throughout theages accountants have kept track with their
  • 183. fingers, abacuses, and calculators. Inmodern times accounting has gone beyondthe physical count of grain in storage.Accounting answers these basic questionsabout a business:
  • 184. What does a company own?How much does a company owe others?How well did a company’s operationsperform?How does the company get the cash tofund itself?All corporate activities must eventually bemeasured in dollars, and that is whereaccounting comes in, like it or not. Althoughthis area may appear tedious, you musthave a working knowledge of accounting tofunction in the business world. Becauseknowledge is power, MBAs need to beliterate in accounting to understand itsfunction; more important, they must be ableto ask for and use accounting informationfor decision-making purposes. Lawyers
  • 185. with accounting knowledge, for example,can interpret financial statements to getvaluable information. In settlementnegotiations, they become a force to bereckoned with. Because employeeperformance is often evaluated withaccounting data, a knowledge ofaccounting is essential.Having expert knowledge of complexaccounting rules, however, is not theMBA’s goal. Therefore, my aim here is togive you the basics, not to make you aCPA. Because every function of business,including finance, operations, andmarketing, uses the numbers generated bythe accountants, it is very important tograsp the fundamentals and read thischapter carefully.
  • 186. Gaap RulesAccounting has innumerable rules. Youshould not attempt to memorize them, butyou should become sufficiently familiar withthem to communicate with CPAs.Accounting rules set the standards so thatfinancial reports of companies may becompared on an equal basis. Accounting’sgoverning rules are called GenerallyAccepted Accounting Principles (GAAP).These “Gap” rules have been developedover the years and are analogous to theprecedents in the legal profession.As new areas of business activity develop,the Financial Accounting Standards Board(FASB) writes additional rules to deal withthese situations. This body has generatedover a hundred “Fasbee” rules over theyears and accountants refer to them by
  • 187. number. For example, FASB 90 was issuedin 1987 because of the problems of faultynuclear plant construction. Electric utilities,such as WPPSS (“Whoops”) in theNorthwest, needed guidance on how toaccount for the abandonment of billions ofdollars of unsafe and unnecessary plantfacilities.The Fundamental Concepts of AccountingTo understand accounting, before you getinto the numbers you first must becomefamiliar with the underlying concepts. Therules do not tell the whole story. Thefollowing seven concepts and vocabularyare not a set of laws, but rather a guidingset of policies that underlie all accountingrules and reporting.
  • 188. The EntityCash and Accrual AccountingObjectivityConservatismGoing ConcernConsistencyMaterialityThe EntityAccounting reports communicate theactivities of a specific entity. Theparameters covered by an accountant’sreport must be clear. A reporting entity canbe a single grocery store, a productionplant, an entire business, or aconglomerate. For example, General Millsprepared reports for each of its Red
  • 189. Lobster restaurants. It also reported on theentire chain of Red Lobster restaurants, aswell as its restaurant group, which alsoincludes the Olive Garden chain. Of course,there is an overall report for the wholecorporation which includes Cheerios, BettyCrocker, Gold Medal flour, and Yoplaityogurt. In 1995, General Mills spun off itsrestaurants into a separate company,Darden Restaurants. The operations werealready segregated and ready to becometheir own independent entity.Cash Basis Versus Accrual AccountingHow the beans are being counted is veryimportant. Using cash basis accounting,transactions are recorded only when cashchanges hands. Very small businesses canget all the accounting information they needfrom their checking account register. If a
  • 190. store pays two years’ rent in 2000, all therent cost would be recorded as a cost in2000, not over a period of two years. Whena small machine shop purchases a powertool, its cost would be recorded when it waspurchased, not over the useful life of thetool. Get the idea? Cash accounting tellsyou when and how much cash changedhands, but it doesn’t try to match the costsof conducting business with their relatedsales.Most companies of any significant size usethe accrual accounting method. Accrualaccounting recognizes the financial effectof an activity when the activity takes placewithout regard to the movement of cash.Kmart’s rental costs are recorded eachmonth with the benefits of occupancy. Thecost of rivet guns at Boeing’s aircraft
  • 191. factory is recorded over the useful life ofthe tools as workers use them on thefactory floor. Due to the dollar magnitude ofBoeing’s purchases, cash accountingwould distort its financial statements.Accrual accounting, as a consequence,raises two related issues, allocation andmatching, because activity and cashmovement most often do not occur at thesame time.Allocations to Accounting Periods. Becauseprofit and loss statements reflect activitiesover a specific period of time, the period ofrecognition is very important. If IBM sold alarge computer on credit to Ford MotorCompany on December 31, 2000, accrualaccounting would record the sale in 2000when the binding contract was signed, not
  • 192. when Ford actually laid out the cash in2001. The sale could be recorded at thatpoint, because it was then that Fordbecame legally bound to take delivery ofthe computer. That was also the period inwhich IBM’s accounting records wouldrecognize the sale and its related costs andthe profits. Ford, on the other hand, wouldrecognize or accrue and allocate the cost ofusing the computer over its useful life.Matching. Using the same logic as inallocation, sales made in one period arematched with their related selling costs orcost of goods sold (COGS) in the sameaccounting period. By matching salesdollars with their related costs, you canfigure the profit a company has actuallymade. For example, when Safeway sells
  • 193. fresh produce on December 31, 2000, butdoesn’t pay the supplier’s bill until 2001,accrual accounting will nevertheless recordthe costs related to those sales in 2000.Safeway’s sales in 2000 caused theexpense, and therefore, the sales shouldhave the related costs allocated againstthem in the same year. Without establishedpolicies for allocation and matching,accountants could easily manipulatefinancial reports by choosing when torecord sales or expenses in order to coverup or delay bad results.Transaction Definition and ObjectivityAccounting records only containtransactions that have been “completed”and that have a “quantifiable” monetaryvalue. Sales that have not been completed,but are thought of as “sure things,” cannot
  • 194. be recorded. Even if a trustworthysalesman from Navistar (formerlyInternational Harvester) swears that farmerJones is a sure bet to buy a combine, theaccountant would say no. For hisaccounting purposes, the sale has nottaken place. Navistar has not delivered themachinery, nor has the farmer signed anenforceable contract.Accountants also have an objectivity rule toguide them when in doubt. There must bereasonable and verifiable evidence tosupport the transaction, or else it does notget recorded.For example, the goodwill generated by apublic service campaign cannot berecorded on the books. What value couldyou put on it? Archer Daniels Midland(ADM) regularly runs TV propaganda telling
  • 195. consumers how cheap food is in Americacompared with the rest of the world. Howcould an accountant objectively put a dollarvalue on the “good feelings” directedtoward the company in the hearts ofgrateful Americans or incumbentcongressmen? Patents and inventions arealso hard to value. If Du Pont purchases apatent on a new chemical from an inventorfor $1,000,000, it would be recorded on thebooks at $1,000,000. The patent hasquantifiable market value. However, if a DuPont scientist developed a new process inthe lab, the accountants could not recordthe innovation until it was sold. Theaccountant would need to have a contractand a canceled check to substantiate theentry in the books.
  • 196. Accounting Conservatism and HistoricalCostsWhen companies incur losses that areprobable and that can reasonably beestimated, accountants record them, evenif the losses have not actually beenrealized. When gains are expected,accountants postpone recording them untilthey actually are realized. If in 1986 themanagement of International PaperCompany anticipated a big profit in 1988 onthe sale of their Manhattan corporateheadquarters, they could not record theirprofit until 1988. Their move to Memphiswas uncertain. Management could havechanged their minds, or the real estatemarket could have tumbled. But for thesake of argument, let’s assume thatInternational Paper discovered in 1986 that
  • 197. in 1988 it would have to clean a toxic-wastepool beneath its building. Managementwould have to hire a consultant to estimatethe cost of cleanup and record that cost in1986. In this way, the financial statementreaders would be warned of dark cloudslooming over the horizon in 1988.Accounting conservatism governs thepreparation of financial statements. Whenin doubt, be conservative. Accountingrecords contain only measurable andverifiable properties, debts, sales, andcosts.Conservatism also dictates thattransactions be recorded at their historicalcosts. International Paper’s New Yorkheadquarters appreciated in value duringthe real estate boom of the 1980s, and yetthis gain could not be recognized, even if
  • 198. the company had paid the Indians a fewtrinkets for it in the 1600s. The recordscontinue to value the real estate at the costof the beads given to Indians in exchangefor the property. In the accountant’s mind,the value of the building may decline by thetime it’s sold.If the value of an asset falls below therecorded cost, that’s another story.Conservatism dictates that the loss berecognized today. To do otherwise couldmislead the reader of a financial statementto believe that the assets represented areat least worth their historical cost.The value of goods held in inventory is alsostated at historical cost. Even if priceschange, the objective price is that which thebusiness paid historically. There must beverifiable purchase orders and bills to
  • 199. support the cost. For instance, if Ginn’sOffice Supplies carries notepaper producedby International Paper on its books, it wouldvalue the paper at cost. Even if reordercosts for the same inventory had gone up,the cost of the merchandise on hand wouldremain at Ginn’s historical cost on thebooks.Going ConcernFinancial statements describe businessesas operating entities. The values assignedto items in the accounting records assumethat the business is a going concern.Accountants presume that companies willcontinue to operate in the foreseeablefuture, therefore, the values assigned in thefinancial statements are not “fire sale”prices. They use historical costs, as youalready know. Steel rolling equipment, for
  • 200. example, is expensive to purchase. It mayhave great value to an ongoingmanufacturing company such as US Steel,but put up for sale at a bankruptcy auction,its value would be pennies on the dollar.Used industrial equipment has limitedvalue to outsiders. Accordingly, accountingrecords use historical costs assuming thatthe company is using its machineryproductively.ConsistencyThe consistency concept is crucial toreaders of financial statements. Accountingrules demand that an entity use the sameaccounting rules year after year. Thatenables an analyst to compare past withcurrent results. This rule, like the otherspresented earlier, tries to minimize thetemptations of accounting monkey
  • 201. business that businessmen like to engagein to cover up bad results.The consistency rule insists that companiesvalue their inventory the same way fromyear to year. The major methods availableare a FIFO (First In First Out) or LIFO (LastIn First Out) basis. Using FIFO, the oldestpurchase costs of goods are recognized ascosts “first,” leaving the most recentlypurchased cost of goods in the value ofinventory held for sale. Using LIFO, the“last” costs of goods are recognized ascosts first, leaving the oldest costs in thevalue of inventory. The accounting methodis independent of the physical movement ofinventory. It is just an accounting method.As you might imagine, if you could changeaccounting methods at will, a craftyaccountant could manipulate the financial
  • 202. statements from year to year. Consistencyrequires that the same accounting methodbe used from year to year.As an example of FIFO and LIFO methods,consider a coin dealer who has only twoidentical gold coins in his showcase. Onehe bought in 1965 for $50, and the other hepurchased in 2000 for $500. A numismatistcomes to his shop and buys one of thecoins for $1,000. Using FIFO, the shopowner would record a sale of $1,000, a costof $50, and a resulting profit of $950 in hisaccounting records. His remaininginventory would reflect one coin at ahistorical cost of $500. The cost of the firstcoin purchased was the first to be recordedas a cost of goods sold. Using the alternateLIFO method, the owner would record acost of $500, and a profit of only $500. His
  • 203. inventory records would show a coin with avalue of $50. The last cost was used first.Which coin was actually sold, the 1965 orthe 2000 acquisition, does not matter. It’sonly an accounting method. But the methodchosen dramatically affects the way acompany calculates profits and valuesinventory. That does matter.If a change of accounting method isnecessary for a “substantial” reason, thefinancial statements must state the reasonin the Footnotes located at the end of thereport. The footnotes must state thechange and its justification. The footnotemust also state how the change affectedthe profits and asset values that year. Youcan run, but you cannot hide from theaccountants.
  • 204. MaterialityAn important caveat of financial statementsis that they are not exact to the penny,even though you would expect thattenacious accountants would produce suchreports. In fact, they are only materiallycorrect so that a reader can get a fairlystated view of where an entity stands.Financial statements give a materiallyaccurate picture so that a reasonableperson can make informed decisions basedon the report. For a small soda fountain’sfinancial statements, a one-hundred-dollarerror may materially distort the records,while a ten-dollar error may not. In contrast,huge multinational companies like Coca-Cola may have million-dollar errors in theirreports and not materially distort the picturefor decision making.
  • 205. By now you can begin to develop an insightinto how accountants think aboutbusinesses and possibly why they are, forthe most part, conservative even as people.I found the cartoon on page 72 on thebulletin board at Arthur Andersen LLP, oneof the Big Five international accountingfirms, where I worked as a CPA for threeyears and had conservativism burnt into mypsyche. I still wear white button-downcollared shirts out of habit. The Financial StatementsMBAs are not trained to key transactionsinto a computer; rather they are schooled tointerpret the information that accountantsgenerate. The financial statements are thesummary of all the individual transactionsrecorded during a period of time. Financial
  • 206. statements are the final product of theaccounting function. They give interestedusers the opportunity to see what went onin a neat summary. To know a company,you must be able to read and understandthree major financial statements:
  • 207. The Balance SheetThe Income StatementThe Statement of Cash FlowsThe Balance SheetDefinitionsTo set the stage you need to know thebasic vocabulary of the balance sheet. Thebalance sheet presents the assets ownedby a company, the liabilities owed to others,and the accumulated investment of itsowners. The balance sheet shows thesebalances as of a specific date. It is asnapshot of a company’s holdings at agiven point in time. The balance sheet isthe foundation for all accounting records,and you must be familiar with it. Thefollowing are the components of balancesheets.
  • 208. Assets are the resources that the companypossesses for the future benefit of thebusiness.- Cash- Inventory- Customers receivables—accounts receivable- Equipment- BuildingsLiabilities are dollar-specific obligations torepay borrowing, debts, and otherobligations to provide goods or services toothers.- Bank debt- Amounts owed to suppliers—accounts payable- Prepaid accounts or advances from customers to deliver goods and services
  • 209. - Taxes owed- Wages owed to employeesOwners’ equity is the accumulated dollarmeasure of the owners’ investment in thecompany. Their investment can be either inthe form of cash, other assets, or thereinvestment of earnings of the company.- Common stock—investment by owners- Additional paid-in capital—investment by owners- Retained earnings—reinvestment of earnings by ownersThe Fundamental Accounting EquationAs the name implies, the balance sheet is a“balance” sheet. The fundamental equationthat rules over accounting balance is:Assets (A) = Liabilities (L) + Owners’ Equity(OE)
  • 210. What you own (assets) equals the total ofwhat you borrowed (liabilities) and whatyou have invested (equity) to pay for it. Thisequation or “identity” explains everythingthat happens in the accounting records of acompany over time. Remember it!Examples of the “Balancing” ActUsing the example of a new localsupermarket called Bob’s Market, I will giveyou three examples of how the balancingact works.
  • 211. 1.When the market opened up for business, Bob purchased a cash register. Assets increased on the left side of the scale, while bank debt, a liability, was also increased on the right to pay for it. The asset increase was balanced by an increase in liability.2.When Bob invested some of his own money and attracted some of his father’s in order to open the market, equity increased on the right side of the scale, and cash, an asset, increased on the left to balance the transaction.3.When the store becomes successful, it will hopefully be able to pay off its bank debt for the register (liabilities reduced on the right). The cash, an asset, would be reduced, thus balancing the transaction
  • 212. on the left.All transactions adhere to this balancingconcept. There is no way to affect one sideof the balance sheet without a balancingentry. The accounting records are thereforesaid to be in “balance” when the assetsequal the liabilities and owners’ equity (A =L + OE). If the records do not balance, anaccountant has made a mistake.The Accounting Process: The Double EntrySystemAs you may have heard, accountants makejournal entries in their books to record eachof a business’s individual transactions.Accountants call their books the generalledger. Using the same balancing conceptshown by accounting’s fundamentalequation, asset additions are placed on theleft side, called a debit. Liabilities and
  • 213. owners’ equity additions are placed on theright side, called a credit. In all cases,journal entries have at least two lines ofdata, a debit and a credit. Entries to reduceassets are placed on the right, a credit, andreductions of liabilities and equity areplaced on the left, a debit. Because of thisright side/left side method, the manualrecord keeping of each account’stransactions resembles a “T,” andconsequently these records are called “T”accounts.Rules for Entries into Accounts
  • 214. To illustrate, at the beginning of the yearBob and his father issued themselves1,000 shares of stock for their initialinvestment of $15,000 in their store. Thejournal entry to record the transactionlooked like this:Balance Sheet Journal Entry #1Similarly a repayment of a debt would bejournalized as:Balance Sheet Journal Entry #2Because each entry to the recordsbalances, at the end of a period of time, theentire balance sheet that summarizes the
  • 215. individual “accounts” and their net endingbalances also balances (A = L + OE).A Balance Sheet ExampleLet’s continue with the local grocery storeexample and see what balances appearedduring its first year of operation.Bob’s MarketFairway, KansasBalance Sheet as of December 31, 2000(the first year of operation)
  • 216. Bob’s statement resembles the typicalbalance sheet of many retail andmanufacturing firms. Three things are worthnoting. The total of assets equals the totalof liabilities and owners’ equity. Second,the assets are on the left and the liabilitiesand OE are on the right, just like the journal
  • 217. entries of debits and credits. The thirdnoteworthy item is that the balance sheet isas of a point certain in time, December 31,2000, a specific date. Even though abusiness is the result of buying and sellingover time, the balance sheet is only a“snapshot” of what the company’sresources and obligations are at a statedtime.Liquidity: Current and Long-TermClassificationsAn important aspect of the balance sheetstatement is that the assets and liabilitiesare listed in order of their liquidity, frommost liquid to least. Liquidity means theability of an asset to be converted to cash.Cash, Accounts Receivables fromcustomers, and Inventory are labeledcurrent and are listed first since they are
  • 218. easily transferred and converted into cashwithin the next operating period, typically inone year (i.e., they are liquid). Equipment isnot very easily sold, therefore it is classifiedas fixed, long-term, or a noncurrent asset(NCA) and listed below the current items.Check out Bob’s balance sheet to verify theplacement of these items.On the liabilities side, the accounts payableto suppliers, wages payable to employees,and taxes payable are current liabilities.They are short-term obligations that willhave to be paid within a year. The bankdebt is long-term or a noncurrent liability(NCL) because it will be paid off over aperiod of years.Working CapitalA commonly used term in accounting aswell as finance is working capital. It refers
  • 219. to the assets and liabilities that a companyconstantly “works with” as part of its dailybusiness. They are also the most liquidassets, giving a financial statement readera clue to a firm’s solvency. Consequently,working capital items are the current assetsand liabilities of the firm. Net workingcapital, a measure of solvency, is the totalof current assets less the total of currentliabilities.Current Assets Current Liabilities = NetWorking CapitalAt Bob’s Market net working capitalamounts to $28,000 ($115,000 $87,000).That’s Bob’s excess of liquid assets tomake good on its current obligations. Froma banker’s vantage point, a grocer with alarge amount of net working capital may beconsidered a good credit risk because the
  • 220. business can make its debt payments.Conversely, it could also show a corporateraider or operations analyst that the storeowner is mismanaging his inventory byholding too many goods on the shelves ortoo much cash in the registers. An astuteoperator would reduce inventory levels andthe cash on hand to more efficient levelsand pocket the difference as a dividend.The proper amount of working capitaldepends on the industry.How Owners’ Equity Fits InOwners’ equity represents the long-termobligation of a company to its owners.Companies are obligated to pay the ownersa return on their investment based on thesuccess of the firm. OE does not carry aset rate of interest or maturity like a bankloan, so it is segregated below the
  • 221. liabilities. Owners are paid only after allother debt payments are made. An owner’sreturn is dependent on the success of thecompany. If debt repayments cannot bemade, the firm can be forced intobankruptcy. The inability to pay a dividendto investors has no such penalty. If thecompany is highly profitable, the ownerswin. If not, they can lose all of theirinvestment. That’s the risk of ownership.By reversing algebraically our accountingidentity from A = L + OE to OE = A L, youcan see that OE is the “residual” interest ofthe firm, assets less liabilities. OE is alsocalled net worth, as it is the “net” value afterall other obligations. In the case of DonaldTrump, the notorious real estate magnateof the 1980s, he may have owned billionsof dollars of property, but temporarily his
  • 222. net worth reportedly became negative in1990 as his debts became even larger thanthe value of his properties in New York Cityand Atlantic City.Owners’ equity is increased by conductingbusiness. Businesses buy and sell andprovide and receive services. Hopefullyafter a period of time, the company hasincreased its wealth with those activities. Ifthe net assets increased over time then itmust have increased its OE.The OE captions on the balance sheet canbe affected in two ways. Investors cancontribute more funds or they may electthat the company “retain” its profits. Theline “Retained Earnings” is on the balancesheet for that purpose. If owners want totake out earnings they may elect to receivedividends. Dividends reduce their
  • 223. accumulated retained earnings.Accountants sometimes prepare theStatement of Owners’ Equity with thefinancial statements if the information isuseful. These detailed statements outlinethe owners’ investments, their stocktransactions, and the dividends paid tothem during the year. These transactionsaffect the owners’ equity captions on thebalance sheet. The Statement of Owners’Equity, also called the Statement ofChanges Shareholders’ Equity, isconsidered a minor statement. However, itmay be very important for companies thathave a great deal of owner activity. Largecompanies always produce this statementbecause it reveals many transactions thatinterest the public. Take a moment and goback to Bob’s balance sheet and review its
  • 224. presentation before you move on to theincome statement.The Income StatementAs the balance sheet shows balances as ofa specific date, the income statementshows the “flow” of activity and transactionsover a specific “period” of time. That periodmay be a month, a quarter, or a year.There are revenues from sales andexpenses relating to those revenues. Whenrevenues and expenses are properlymatched using accrual accounting, thedifference is “income.”Revenue Expenses = IncomeAn Income Statement ExampleLet’s look at the income statement of Bob’sMarket to see how his operation performedduring his first year of business.
  • 225. Bob’s MarketFairway, KansasIncome Statement for the Year EndingDecember 31, 2000
  • 226. Income Statement TerminologyAs with the balance sheet, the incomestatement has several noteworthy features.In the income statement, the classificationsof expenses are extremely importantbecause different types of income arecalculated. Each offers a particular insightabout Bob’s operating results. Please referto Bob’s income statement as you readthrough this terminology section.Gross Margin. The top part of the incomestatement calculates gross margin.Gross Margin =Sales The “Direct” Cost of the Goods orServices Sold
  • 227. At this point, the reader can determine ifthe company is making a profit withoutconsidering the burden of corporateexpenses. At Bob’s Market gross marginwas his sales less the cost of goods sold(COGS). COGS includes the cost ofgroceries and all costs “directly” related tomaking the groceries salable, such as thecost of shipment from the wholesaler. In amanufacturing company it includes thecosts of production, materials, and labor. Ina simple retail situation like Bob’s, COGS iscalculated by this formula:Beginning Inventory + New PurchasesEnding Inventory = Cost of Goods SoldIf a business has a negative gross margin,either costs are out of control, or the pricingstructure of the industry does not afford thecompany a profit. A small electronics
  • 228. manufacturer would encounter this situationif it tried to compete with the Japanesevideo recorder manufacturers, Sony,Hitachi, and Panasonic. A small U.S.manufacturer could not be as efficient andcould not charge a higher price to cover itshigher costs of production.Operating Profit. The next part of theincome statement relates to the operatingprofit of the company, the earnings beforeinterest and taxes (EBIT). The further wemove down the income statement, themore expenses that are deducted. At theoperating level of profit measurement, allthe other corporate expenses directlyrelated to the revenue process arededucted. In Bob’s case he has employeewages, rent, utilities, advertising, and manyother smaller items.
  • 229. Accrual accounting dictates that theallocated cost of fixed assets, also calleddepreciation, be charged to earnings. Usingthe principle of matching, the cost ofproviding the company’s products ismatched with its related revenues of theperiod. Accountants divide the cost ofequipment, tools, buildings, and other fixedassets by their useful lives to estimate thecost of using up assets needed in therevenue-generating process. In Bob’s case,he spent $30,000 for shelves, carts, andcash registers. Because he estimated thatthey will last 10 years, Bob’s incomestatement will show an expense of $3,000($30,000/10) each year to match andallocate the cost of using those assets withthe period of sales benefited.
  • 230. “Other Expenses” is a catchall category foritems not large enough to justify a separateline on the income statement. On Bob’sincome statement it includes fixing thoseannoying stuck wheels on his shoppingcarts and the losses on bad checks.Net Income. Below the operational level ofprofit, items not directly linked to operationsare deducted to calculate income. The firstis the interest expense for the period. Acase can be made that corporate borrowingis used to support the operation. However,the method of financing the company isseparate from the operating activities of thebusiness. Accountants do not includeinterest in operating income, becausecompanies in similar businesses may havebeen funded by using differing proportionsof bank borrowing and investors’ money.
  • 231. Investors’ dividends are not deducted.Owners pay dividends out of the netincome at the bottom of the statement.If interest were to be included in operatingincome, similar companies could havevastly differing operating incomes just bythe way they funded their cash needs. Acompany under a different managementcould fund all its cash needs by additionalinvestments from its owners. These fundswould incur no interest charges, and,therefore, the company’s operating incomewould be higher. If the same companyborrowed for all its needs, its operatingincome would be reduced by the interestexpenses. By segregating interestexpenses, the operating income reflectsonly the costs of “operating” the company,rather than “financing” it.
  • 232. Using the same logic that excluded interestfrom operating income, tax expenses aresegregated to leave operating income freeof nonoperating expenses. Different taxstrategies can result in greatly different taxexpenses. Because taxes are often theproduct of a skilled tax accountant’s peninstead of operating results, tax expensesare put below operating results as aseparate deduction, leaving net income asthe final measure of income. Net income isthe bottom-line profit of the company and itis the figure that is reported in the media asthe measure of success or failure.How Income Statement Journal Entries AreMadeIn keeping with their age-old duty to countthe beans, accountants make journalentries to the company’s books to tally up
  • 233. net income during the year. Net income isthe result of subtracting the expenses fromthe sales made during a defined period oftime. Net income is also the net increase inassets for the same period of time. Journalentries keep track of the total of all therevenues and expenses as well as theircorresponding increases and decreases inassets. Accountants make the entries forthe income statement at the same time asthey prepare the balance sheet.During the year, running totals areaccumulated for each revenue andexpense to calculate the final net incomefigure for the entire year. At year’s endwhen the final tally is completed and netincome is calculated, the running totals ofrevenues and expenses are set to zero forthe new year and the difference or net
  • 234. income or loss is recorded on the balancesheet as retained earnings. Thataccounting year, at times called a fiscalyear, can begin in any month. It does nothave to start in January.The journal entries look the same as thosethat you have seen used for the balancesheet. To track the income statement,revenues are recorded as credits (on theright side) and expenses are recorded asdebits (on the left).Income statement entries are combinedwith balance sheet entries. A sale meansthat the business received something ofvalue, an asset, in exchange for somethingelse of value, an expense. At Bob’s grocerystore, sales meant that an inflow of cashcame in exchange for grocery inventory.Bob’s accountant made weekly entries to
  • 235. record his sales and their costs in thefollowing way:Income Statement Journal Entry #1Similarly the accountant recorded the costof those sales:Income Statement Journal Entry #2To illustrate a full year’s income statemententries, assume that those two entries werethe only sales and costs for the entire year.The net income for the year would havebeen the net of the total sales revenues of$100,000 less the total COGS of $95,000,or $5,000. That net income figure also
  • 236. mimicked the change in net assetsrecorded by those same entries. Cashincreased $100,000 and groceriesdecreased $95,000, a net of $5,000.At year’s end the net increase of assets of$5,000 equals the net income for the year.Bob would have recorded that net changeon the balance sheet as an increase toretained earnings. He would also close outor set to zero all the revenue and expenseaccounts for the year in preparation forrecording the next year’s activity in thefollowing entry:Income Statement Year End Close OutEntry
  • 237. Notice that the journal entry balances. Theincome statement entries reversedthemselves, leaving the net incomeaddition to retained earnings on thebalance sheet. Where sales of $100,000were entered on the right during the year,they are cleared at year end with a$100,000 entry on the left. The balancesheet’s asset, liability, and owner’s equitybalances are permanent running totals thatare carried forward to the next accountingyear. There you have it. In a page you’vewitnessed an abbreviated version of anentire year’s accounting cycle and hours ofMBA classroom consternation.The Income Statement’s Link to theBalance SheetFrom Bob’s actual income statement, thereader can see that the store had a
  • 238. marginally profitable year. He had a netincome of $30,000. What is even moreimportant than just the calculations ofincome is the understanding of how theincome statement relates to the balancesheet. The income statement is the resultof many activities during the year. Assetsand liabilities are affected upward anddownward during the year through manyindividual transactions. At year’s end, thenet assets of the firm, as totaled by thebalance sheet, had changed because ofoperating activities. The net income, ascalculated by the income statement, tellsthe story of the year’s operations byshowing how that change in net assetsoccurred. Because it was Bob’s first year,retained earnings equaled $30,000, the firstyear’s net income. In succeeding years itwill be affected by the next year’s earnings
  • 239. and dividends.The Statement of Cash FlowsThe Importance of CashAs the saying goes, “Cash is king.” Withoutthe green a business cannot function. Forexample, let’s take a look at Leonard, Inc.,who sold package printing equipment to thefood companies that supplied Bob’sMarket. If Leonard, Inc., sold three printingpresses to Ralston Purina at $5 millioneach and earned $2 million on each,Leonard’s income statement would show$6 million in profits. However, Leonardmanufactured the equipment during thesummer and Ralston paid for it in the fallwhen it was delivered. The factoryemployees wouldn’t be too happy if theirJuly paychecks bounced while thecompany waited for the cash in October.
  • 240. Because the cash is critical for operations,and most important in order to stay out ofbankruptcy, the FASB wrote rule No. 95mandating that all financial statementsinclude the Statement of Cash Flows orCash Flow Statement. Remember thoseFASB rules that I mentioned accountantsmake to address current businessconcerns? Because knowing the “sources”and “uses” of cash is paramount for abusiness, the addition of the statement ofcash flows has been widely seen as a greatimprovement by the financial community.The inability to manage a company’s cashneeds is often the primary cause of thedemise of many “profitable” enterprises.Many companies that measured theirsuccess by their net income have had arude awakening when confronted with cash
  • 241. shortages and angry creditors. This is justwhat happened to Chrysler in 1979 when itwent hat in hand to the federal governmentfor a bailout.Investors myopically looking at the incomestatement for a measure of health can bedeceived. For example, McDonnellDouglas, the defense contractor, hadhealthy earnings in 1990 that masked anunderlying corporate illness. Forbesreported it to its readers:On the surface, things don’t look so bad forMcDonnell Douglas. It will probably reportover $10 a share in earnings in 1990,versus $5.72 last year. But even a cursoryglance examination of the numbers showsthat earnings are shaky, if not ephemeral.Start with cash flow. It was negative $35million by the third quarter of 1991…and
  • 242. the bleeding of cash could accelerate….The leveraged buyout (LBO) phenomenonof the 1980s used the principles of cashflow as its tool. A raider’s ability to repaythe money borrowed to acquire a targetcompany was based in large part on thecash flow generating ability of theacquisition. Much of that information lies inthe statement of cash flows. In 1989Kohlberg Kravis Roberts (KKR) boughtRJR Nabisco in the largest leveragedbuyout up to that time with $26.4 billion indebt financing based on the cash-generating ability of the company to pay offthe debt.The Cash Flow Statement’s Link to theBalance SheetThe cash flow statement also follows thebalancing act principle of accounting. I will
  • 243. present the accounting math first so thatyou may understand the logic of what, atfirst glance, can be a confusing statement.With the math out of the way, the cash flowstatement example can be readilyunderstood. The equations that follow arenot included to impress, merely to inform.Using the golden fundamental accountingequation we have:A = L + OEAssets = Liabilities + Owner’s EquityBecause assets and liabilities arecomposed of both current (short-term) andnoncurrent (long-term) items, the equationcan be expanded:CA + NCA = CL + NCL + OE
  • 244. Current Assets + Noncurrent Assets =Current Liabilities + Noncurrent Liabilities +Owners’ EquityTo further break it down, the current assetclass can be shown as its individualcomponents:(Cash + Accounts Receivable (AR) +Inventory (INV) + NCA = CL + NCL + OERearranging the equation algebraically, wecan isolate cash:Cash = CL + NCL + OE AR INV NCAAs revealed by the equation, an increase ina current liability (CL) on the right of theequals sign would mean an increase incash on the left. Increasing your debts tosuppliers frees up a business’s cash forother purposes. Conversely an increase inan asset such as Inventory would mean a
  • 245. decrease in cash. It makes sense; buyinginventory requires cash. Adding orsubtracting on one side of the equals signaffects the total on the other side of theequation.My study group at business school foundcash flow statements to be the mostconfusing of the major topics in accounting.But if the former Peace Corps volunteer inmy study group with no business trainingcaught on, I have full confidence in yourability to pick it up also. With the precedingas foundation, I will illustrate theimportance of the cash flow statement anduse Bob’s Market as an example to finishoff the cash flow lesson.The Uses for the Cash Flow StatementThe cash flow statement is a managementtool to help avoid liquidity problems. Both
  • 246. the income statement and the balancesheet are used to form the cash flowpicture of a company. The statementanswers the following important questions:What is the relationship between cash flowand earnings?How are dividends financed?How are debts paid off?How is the cash generated by operationsused?Are management’s stated financial policiesreflected in the cash flow?By using a statement of cash flows,managers can plan and manage their cashsources and needs from three types ofbusiness activities:
  • 247. Operations ActivitiesInvesting ActivitiesFinancing ActivitiesThese activities are shown clearly in thecash flow statements.A Cash Flow Statement ExampleLet’s look at Bob’s Market as a springboardfrom my theoretical discussion and get intoan actual cash flow statement.Bob’s MarketStatement of Cash Flows for the yearEnding December 31, 2000
  • 248. It is easy to get too wrapped up in thenumbers and not really grasp the logicbehind the preparation of the statement.Therefore, let’s look at each entryseparately and explain the logic behind it.The MBA’s accounting education focuseson the logic behind the numbers, whileundergraduate programs focus primarily onthe accounting mechanics to turn outCPAs, not MBA managers.Please refer to Bob’s cash flow statementduring the following discussion.Operating ActivitiesIn the Operating Activities section,accountants calculate the cash generatedfrom the day-to-day operating activities of abusiness. The income statement showed
  • 249. “accounting profit” of $30,000 for Bob, but itdid not show how much cash was used orgenerated by his operations. As I explainedearlier, most companies use accrual basisaccounting, as Bob has, to determine hisnet income. The cash flow statementconverts that accrual basis net income to acash basis. To do that the net income hasto be adjusted in two ways to get back to acash basis.Step 1. Adjust Net Income for NoncashExpenses. The first step to determine theflow of cash is to adjust the net incomefrom the income statement. Operatingitems that did not use cash, but werededucted in the income statement as anexpense, must be added back.Depreciation, as explained in the income
  • 250. statement section, does not actually takethe company’s cash “out the door.” Onlywhen Bob purchased the carts, registers,and displays was cash used. But over thelife of these assets, depreciation is only an“accounting cost” that matches the originalcash expenditure for these assets with thesales they benefit. Therefore, depreciationmust be added back. It is not a use of cash.The purchases of the assets themselvesare included later in the Investing Activitiessection.Step 2. Adjust Net Income for Changes inWorking Capital. Net income must also beadjusted for the changes in current assetsand current liabilities that operationalactivities affected during the year. Byadjusting net income for working capital
  • 251. increases and decreases, we candetermine the effect on cash by using thefundamental accounting equation.When Bob increased his current assets,such as his shelf inventory, he used cashbecause it took cash to buy groceries. Thisis shown as subtractions on the cash flowstatement. When he extended credit to hiscustomers, it delayed his receipt of cash,thus “using” cash that the store could havebeen using for other purposes. This is alsoshown as a subtraction on the statement.Conversely, reductions in inventory, i.e.,sales, would have increased Bob’s cash. Ifreceivables had declined, i.e., customers’payments, cash would have beengenerated. Point of Learning: Increases incurrent assets use cash while decreases incurrent assets produce cash.
  • 252. Current liabilities changes have theopposite effect on cash. In Bob’s case hisvendors advanced him $80,000. When Bobran up a large debt with his vendors andemployees, this meant that credit wasextended to him, which in turn freed hiscash for other purposes. In a sense, cashwas created. If Bob had reduced hisliabilities, that would have meant that hehad made payments to reduce his debts,reducing cash. Point of Learning: Increasesin current liabilities increase cash whiledecreases use up cash.To calculate the net changes for the year,simply subtract the beginning of theperiod’s balances of current assets andliabilities from the ending balances items.Because it was Bob’s first year (and tomake it simple), the beginning balances
  • 253. were all zero and the ending balances areequal to the account increases for the year.The increases in current assets are “uses”and the increases in current liabilities are“sources” of cash.Convince yourself that Bob’s cash flowstatement is correct. Refer to his cash flowstatement. Look back at the incomestatement to verify the net income. Reviewthe balance sheet to check that thechanges in the working capital items (CA +CL) equal the changes shown on the cashflow statement. It all fits together!Investing ActivitiesAs the title explains, this area of the cashflow statement deals with cash use andgeneration by long-term “investments” bythe company. Accordingly, the investmentactivities section reflects the cash effects of
  • 254. transactions in long-term (noncurrent)assets on the balance sheet. When acompany buys or sells a long-term assetlike a building or piece of equipment, thecash relating to the transaction is reflectedin the Investing Activities section of thecash flow statement. In Bob’s case, heinvested $30,000 in store equipment asshown on his statement. If he had sold theequipment, the cash received would havebeen reflected. Review the balance sheetto verify how the change in his long-termassets was reflected in the investingsection of the cash flow statement.Financing ActivitiesThere are two ways a company can financeitself. Either managers borrow money orthey raise money from investors. Borrowingwould be reflected in changes in the long-
  • 255. term liabilities section of the balance sheet.The participation by investors would bereflected in changes in the owners’ equityaccounts of the balance sheet.Bob borrowed $10,000 from the bank,which increased Cash. On the balancesheet, “Bank Debt” increased from $0 to$10,000 and it was reflected as a source ofcash. When the store repays the debt, it willbe reflected as a use of cash in theFinancing Activities section.Referring back to Bob’s Market’s balancesheet, the owners’ equity accounts are onthe right side. The balance sheet showsthat investors contributed $15,000 cash tostart the business. That is shown on thebalance sheet as “Common Stock” issued,and it is also reflected on the cash flowstatement as a source of cash.
  • 256. As we have already learned, the othercomponent of the owners’ equity section isretained earnings (RE). As explained, therewill be changes in RE when net income isadded during the year and if dividends arepaid out to investors. Bob and his fatherelected to continue to “finance” thebusiness by having the company “retain” itsearnings. The financing section,accordingly, does not show any dividendpayments. If the owners elected to pay adividend it would have been shown as ause.After a year of operations Bob had $5,000more than when he started. With his cashflow statement he can understand how ithappened!Once prepared, what does the cash flowstatement mean?
  • 257. Take a step back, or else you can get lostin the mechanics. This cash flow statementshows the net change in cash for the year.It appears at the bottom of the statement.Take a look. It sounds simple, but somenewly minted CPAs I worked with at ArthurAndersen LLP never really understood thatfact as they labored to prepare the report’sdetails. You do. Where the changes in cashtook place is of real importance to MBAs.Was the company a seemingly profitablecompany, but must borrow heavily just tostay alive?Did the company’s operations throw offcash, even though it may be just marginallyprofitable according to the incomestatement?
  • 258. Those are samples of the importantquestions that neither the balance sheetnor the income statement can tell a reader.That is why the cash flow statement exists.When a company is healthy, operatingactivities will generate cash. That messageis delivered by the net income adjusted forchanges in working capital. That is theOperating Activities section’s function.Does the company require a greatinvestment in fixed assets such as newequipment or technology? Is the companyselling off its assets to fill an insatiable cashdrain from operations? That type ofinformation lies in the Investment Activitiessection.Dying businesses stay alive bycannibalizing their assets to fund their
  • 259. unprofitable operations. Pan AmericanAirlines withered in 1991 when it sold itscoveted European routes to its competitorsto raise cash. Pan Am died in 1992. Theairline of the same name today bought thename from the bankrupcy court.Did the company borrow heavily or has thecompany gone to investors to fund itsoperational or investing activities? TheFinancing Activities section tells thatimportant story. In Bob’s case he borrowedfrom the bank and invested his own money.Whatever the sources and uses of cash,the statement of cash flows tells a greatdeal about a business’s health. To manyfinancial analysts, it is the most importantstatement of all.
  • 260. Accounting’s Big PictureA knowledgeable person can always getback to the fundamental equation ofaccounting to make sense of any jumble ofnumbers making up any of the financialstatements of a company: Assets =Liabilities + Owners’ Equity.With the statement of cash flows it wasdemonstrated that the changes during theyear in the cash balance had to result fromchanges in assets, liabilities, and owners’equity. The assets and liabilities changescame from the balance sheet. The owners’equity changes were the result of changesin net income, provided in detail by theincome statement. The three basic financialstatements are inextricably tied together.The fundamental accounting equation, thebalance sheet, and each of the many
  • 261. journal entries made during the year alwaysbalance. That fundamental property allowsfor changes in any piece of the accountingpuzzle to be explained by changes in theother parts. By grasping this basic conceptof the interrelationships of the financialstatements, you have learned the essenceof accounting. Congratulations! Reading the Financial Statements Using RatiosWith an understanding of how accountantscreate their financial statements, let me addsome tools to interpret them: ratios.Absolute numbers in a financial statementin and of themselves often are of limitedsignificance. The real information can befound in an analysis of the relationship ofone number to another or of one companyto another in the same industry—using
  • 262. ratios. In the grocery game, profits areusually low in relation to sales, so grocersmust sell in large volume to make any realprofit. A jewelry store survives on slower-paced sales but higher profits per item.That is why ratios are used to compareperformances among companies within anindustry and against a company’s ownhistorical performance.There are four major categories of ratios:Liquidity measures: How much is on handthat can be converted to cash to pay thebills?Capitalization measures: Is a companyheavily burdened with debt? Are itsinvestors financing the company? How isthe company funding itself?
  • 263. Activity measures: How actively are thefirm’s assets being deployed? (MBAsdeploy assets, rather than just use them.)Profitability measures: How profitable is acompany in relation to the assets and thesales that made its profits possible?There are literally hundreds of possibleratios, but most have their origin in eightbasic ratios from the four categories listedabove. Using Bob’s financial statements, Ihave calculated these eight ratios for hisoperation and have placed them beloweach of the ratio explanations.Liquidity Ratios1. Current Ratio = Current Assets / CurrentLiabilities
  • 264. Can the company pay its bills comfortably?A ratio greater than 1 shows liquidity. Itshows that there is leeway in the currentassets available to pay for current liabilities.Capitalization Ratios2. Financial Leverage = (Total Liabilities +Owners’ Equity) / OEWhen a company assumes a largerproportion of debt than the amount invested
  • 265. by its owners, it is said to be leveraged. Ina profitable company, by using a higherlevel of debt, the return is much higherbecause a smaller amount appears in thedenominator of the ratio. The “same”amount of earnings is divided by a smallerequity base. Ratios of greater than 2 showan extensive use of debt. I will explainleverage more fully when discussing theprofitability ratios.3. Long-term Debt to Capital = Long-termDebt / (Liabilities + OE)Because debt payments are fixedobligations that must be paid whiledividends to investors are not, the level of
  • 266. debt is a very important measure of acompany’s riskiness. A ratio of greater than50 percent shows a high level of debt.Depending on the timing and stability of afirm’s cash flows, 50 percent could beconsidered very risky. Stable electricutilities have predictable sales and cashflows; therefore, ratios over 50 percent arecommonplace. Investment analysts on WallStreet consider those debt levelsconservative.Activity Ratios4. Assets Turnover per Period = Sales /Total Assets
  • 267. This ratio tells the reader how actively thefirm uses all of its assets. The firm that cangenerate more sales with a given set ofassets is said to have managed its assetsefficiently. Ratios are industry-specific.Thirty-six is a high turnover of assets formost industries, but for an antique shop aturnover of three may be considered veryhigh. One-of-a-kind antiques sit waiting forthe right collector to come along. In thegrocery trade 36.6 turns per year is normalbecause the shelf inventory of asupermarket is sold about every week. Theproduce, milk, and toilet paper inventoryturn over several times a week, while theexotic spices take much longer to sell.5. Inventory Turns per Period = Cost ofGoods Sold / Average Inventory HeldDuring the Period
  • 268. (A simple way to calculate “AverageInventory” is by adding the beginning andending inventory balances, then dividing bytwo.)6. Days Sales in Inventory = EndingInventory / (Cost of Goods Sold / 365)These two activity ratios show how activelya company’s inventory is being deployed. Isinventory sitting around collecting dust or isit being sold as soon as it hits the shelf? Ina high-turnover business, like the grocerytrade, there are many turns of inventory
  • 269. during a year and only a few days ofinventory on hand. Most grocery items areperishable and purchased frequently.Profitability Ratios7. Return on Sales (ROS) = Net Income /Sales“Return” ratios are very easy to calculateand investment analysts use themfrequently. They calculate the return on justabout any part of the balance sheet andincome statement. Another common one isthe return on assets (ROA).8. Return on Equity (ROE) = Net Income /Owners’ Equity
  • 270. The mix of debt and equity can dramaticallyaffect the ratios. If a company has a highlevel of debt and a small amount of equity,the return on equity (ROE) can betremendously affected. That is calledfinancial leverage, the term that Imentioned before in discussingcapitalization ratios. To illustrate the point,Bob and his father could have decided toleave very little equity in the company in2000. They could have taken all of the$30,000 of net income made in 2000 out ofthe company as dividends and borrowedfor their future cash needs. If that hadhappened, the balance sheet would havereflected a long-term debt balance of
  • 271. $40,000 ($10,000 + $30,000) and only$15,000 ($45,000 $30,000) in equity. Theresulting debt to equity ratio would increasefrom 7 percent to 28 percent and the returnon equity would have increased from 67percent to 200 percent ($30,000/$15,000).As shown, ratios can be greatly affected bythe financial leverage used. The choice of alower equity level can “leverage” the ROEto extremely high levels.ROE ratio is a widely accepted yardstick tomeasure success. In Forbes’s “AnnualReport of American Industry,” companieswith the greater ROEs were ranked higherthan many of their more profitablecounterparts simply because of theirfinancing choices. If management’s goal isto achieve a higher profitability ratiothrough leverage, there is a risk cost.
  • 272. Higher debt levels require higher interestpayments that a company may not be ableto service if operations do poorly. Thecorporate failures in the 1990s of RevcoDrugs, Southland’s 7-Eleven, andFederated Department Stores were casesin which management risked bankruptcywith high leverage and lost.The Du Pont ChartAcademics have a tendency to giveimposing names to simple concepts. YourMBA vocabulary would not be completewithout including the Du Pont Chart. Thechart shows how several of the mostimportant financial statement ratios arerelated to one another by displaying theircomponents.By charting the interrelationships amongratios, one can see that changes in a
  • 273. component of one ratio affect the otherratios. The ratios share the same inputs.For example, when Total Assets isreduced, both the Asset Turnover andReturn on Assets ratios increase becauseTotal Assets are included in the calculationof both of those ratios as a denominator.Conversely, a reduction of Total Assets(equal to total liabilities and owners’ equity)decreases Financial Leverage as it is usedin that ratio’s numerator.The Du Pont ChartRatios are Industry-Specific
  • 274. Profitability is, as in the case of all otherratios, very industry-specific. Every industryhas a profit level depending on the physicaldemands of the industry. Heavymanufacturers such as steel makers have areturn on assets (ROA) of less than 10percent. They have large steel mills and agreat deal of factory equipment. Servicebusinesses such as profitable head-huntingfirms may have ROAs over 100 percent.The only assets they need are cash, officefurniture, and customer receivables. Theirreal asset is their staff’s talent for nursingand persuading, which cannot be quantifiedon the balance sheet.Profitability also depends on the level ofcompetition. In the grocery business,intense competition keeps the return onsales to a very low 1 percent. During Bob’s
  • 275. first year he had a .58 percent return, whichwas below the industry average.Considering that it was his first year, anyprofit should be commended.Any part of the financial statements can becompared to another with a ratio of somesort. Any calculator can divide one numberby another. Only those ratios that canprovide some insight into a business’sperformance are valuable. The true valueof ratios is seen when one firm’s ratios arecompared to those of another in the sameindustry, or to that firm’s historicalperformance. Alternatively the“attractiveness” of various industries asbusiness opportunities may be explored bycomparing their averages. Each firm andindustry has its own key operating statisticsthat are meaningful.
  • 276. For industry-specific references on all theseratios, Robert Morris Associates publishesits Annual Statement Studies. This valuablereference book, available in most libraries,includes financial and operating ratios forover 300 manufacturers, wholesalers,retailers, services, contractors, and financecompanies. Managerial AccountingManagerial accounting, like ratio analysis,uses accounting data to manage andanalyze operations. Managerial accountingfocuses on operations. Instead of ratiosmanagerial accounting uses standards,budgets, and variances to run the businessand explain operational results. The objectof managerial accounting is to budget acompany’s activities for a period of time,and then to explain why the actual results
  • 277. “varied” from the projections. In mostmanufacturing settings, monthly budgetingand analysis are the norm so thatmanagement can take timely action.To establish a yardstick for measuringperformance, the factory team must setstandards for comparison. This requires theinput from more than just the accountants.In automobile manufacturing, theproduction manager establishes what he orshe believes should be the standard costsfor materials, labor, and other expenses.Industrial engineers help by performingstudies to obtain the data. Factorymanagers work with sales managers tobudget production volumes to meetforecasted demand and also to maintainassembly line efficiency. Sales managersset standard prices and quantities for their
  • 278. products. Using those standards as ayardstick, managerial accountants analyzeactual results to explain the variances fromthose budgets and standards thecompany’s team developed. Oncecompleted, variance analysis highlights thesource of positive or negative results formanagement decision making.Price and Volume VariancesThere are two basic types of variances,price and volume variances. As withfinancial statement ratios, they are derivedfrom simple mathematical formulas.Sales Price Variances. The price variancetells the manager how much of thedifference between budgeted salesrevenue and actual sales revenues is dueto changes in sales price changes.
  • 279. (Actual Sales Price Standard Sales Price)× (Actual Quantity Sold) = Sales PriceVarianceSales Volume Variances. The volumevariance isolates the dollar effect of adifferent unit volume from what wasbudgeted assuming no price changes.(Standard Sales Price) × (Actual QuantitySold Standard Quantity Sold) = SalesVolume VarianceUsing a hypothetical example,DaimlerChrysler AG planned to sell 10,000Dodge Caravan minivans in July 2001 at aprice of $20,000 each for a total of $200million in sales. In August the analystreceived accounting data showing thatsales were actually $380 million in July.Dodge actually sold 20,000 Caravans at anaverage price of $19,000 due to a $1,000
  • 280. rebate program. The total variance of saleswas $180 million. (10,000 × $20,000)(20,000 × $19,000). How did that occur?Variances told the story.The variance solely due to price, the pricevariance, was a negative $20 million($19,000 $20,000) × 20,000 units). Butbecause 10,000 more units were sold thanplanned, the volume variance was a verypositive $200 million ((20,000 10,000 units)× $20,000). The two variances ($20 + $200= +$180) equaled the total variance fromthe total sales budget ($280 $150 =+$130). The variance analysis told theDaimlerChrysler executive in charge of theCaravan model that the overall increase insales was primarily due to a larger salesvolume, rather than to a price increase.Conversely, the small negative price
  • 281. variance due to a rebate was more thanmade up by a stronger sales volume. Whenyou add together the price and the volumevariances they equal the “total” monthlysales variance from budget. The varianceanalysis enabled the Dodge executive toexplain why his results hit his division’stargets.Purchase Price, Efficiency, and VolumeVariancesUsing the same two basic formulas, salesprice and sales volume variances,production departments also calculatevariances for management control.Purchases and usage of productionmaterials have purchase price variances.Purchase Price Variance = (Standard PriceActual Price) × (Actual Quantity Purchasedor Used)
  • 282. The amount of materials and labor used toproduce products may also differ from thestandard amount. Similar to sales volumevariances, these differences are calledefficiency variances. Shoe workers, forexample, can be more efficient by usingmore leather from a hide than planned.Chemically dependent workers on theassembly line in Detroit could take morelabor hours than planned to produce theircars.Material or Labor Efficiency Variance =(Standard Use Quantity Actual UsageQuantity) × (Standard Cost of Material orLabor)Using the Caravan again as an example,the production foreman had budgeted inJuly that each Caravan made should use astandard 8 gallons of paint at a cost of $10
  • 283. per gallon. It actually took 7 gallons at acost of $12 per gallon for the 20,000minivans that were produced. Theaccountant calculated the followingvariances for the Dodge executive:Material Price Variance = ($10 $12 priceper gallon) × (20,000 units × 7 gal.) =$280,000 negative paint price varianceThis was the effect of paying more pergallon than planned. Instead of scratchinghis head, the Dodge executive could usethis information to confront his purchasingagent and demand that he negotiate abetter deal the following month.Material Efficiency Variance = (8 gal. 7gal.) × (20,000 units) × $10 per gallon =$200,000 positive variance
  • 284. This was the effect of using less paint thanplanned.As with ratios, there is an infinite number ofvariances that can be cooked up to keep adepartment of accounting analysts busyfrom now until the next century. There arebasically only two types of variances: priceand volume variances. When you hear thewords “managerial accounting,” thinkvariances.Cost Accounting and Activity- Based CostingCost accounting is the relativelystraightforward process of determining thecost of producing goods and services. It isclosely associated with managerialaccounting, as all its “standards” are basedon the data gathered by cost accountants.
  • 285. With manufactured goods, direct labor anddirect materials are relatively simple toallocate to the cost of a product. However,allocating overhead is much more difficult.More important, if not done properly, it mayfalsely determine profitability of individualproducts and divisions of companies.Overhead must be allocated based on theactual usage of the overhead expenses;hence it is called activity-based costing(ABC). Overhead should be allocatedbased on what it takes to create and deliverthe product to the customer. In the past,overhead expenses were a relatively minorcomponent in relation to materials andlabor costs, but today expenses such astelephone, billing, consultants, andcomputer systems are huge.
  • 286. For example, if a high-revenue division of acompany makes sales to a few vendorswith few orders, it should be allocated lessof the cost of the billing department’s costthan a lower-sales division that has manysmall customers ordering many times ayear. If accountants allocate based onsales, not volume of transactions, the profitpicture would be distorted. When amanufacturing process of a product ishighly automated and that of anotherproduct is not, allocation of computersystem expense based on direct laborhours would be misleading. What oftenhappens in a company is that accountants,detached from the business, arbitrarily ormechanically allocate overhead expenses.That distorts the financial results thatmanagers live or die by. Entire productlines and divisions can be shut down and or
  • 287. outsourced because of these relatively“unimportant” allocation decisions thatneglect their ABC’s. Accounting OverviewI hope you have not struggled too hardthrough this chapter, but in a few pages Ihave tried to give you the essentials ofaccounting from both my CPA backgroundand the MBA curriculum. If the material inthis chapter was totally new for you, mostprobably you have not absorbed itcompletely. You should have rememberedthat:- Assets = Liabilities + Owners’ Equity- There are three basic and interdependent financial statements: Balance Sheet, Income Statement, Cash Flow Statement.
  • 288. - Accounting records and statements always balance.- The statements can be interpreted by using Ratios.- Operating results can be analyzed and managed using Variances.That’s the accounting game in a nutshell.At MBA school accounting struck the mostfear in the hearts of the liberal artsundergraduates. This chapter has givenyou, in a tidy predigested form, what keptthem up late at night. Key Accounting TakeawaysCash Basis Accounting—The method ofrecording transactions only when cashchanges handsAccrual Basis Accounting—The method ofrecording transactions that matches
  • 289. revenues and expenses regardless of cashflow movementsThe Balance Sheet—The listing of what acompany owns and owes at a point in timeThe Fundamental Accounting Equation—Assets = Liabilities + Owners’ EquityNet Working Capital—Short-term assetsless short-term liabilitiesThe Income Statement—The summary ofprofit-generating activities during a periodof timeGross Margin—Revenues less the directcost of goods soldThe Statement of Cash Flows—Thesummary of how a company generates anduses its cash during a period of timeDepreciation—The cost of using equipmentallocated over its useful life
  • 290. The 8 Basic Ratios for Financial StatementAnalysis—A method of analyzingstatements and comparing them to industrystandardsPrice and Volume Variances—A method ofexplaining operational results by isolatingthe effects of price and volume differencesfrom budgeted amountsActivity-Based Costing (ABC)—The methodof allocating overhead expenses based onactual usage, not on arbitrary measure Day 4 Organizational Behavior Organizational Behavior Topics
  • 291. Problem-Solving ModelPsychology LessonMotivationLeadershipCreativityOn-the-Job Office ProcedurePowerThe Organizational Model and StructuresSystems TheoryOrganizational Evolution and RevolutionResistance to ChangeNEW MBA GRADUATE: I have the answer!My Excel spreadsheet says that we shouldreorganize the company by geographicregion rather than by product. We couldsave at least three million dollars a year bycutting unnecessary staff and travel. We
  • 292. hypothetically implemented a similar plan atthe Brandon Lee Company in a classdiscussion. It worked real well.BOSS: Sounds great. You’ve been with thecompany seven months and you want to doa radical reorganization. I assume youalready assembled a roster of redundantemployees?NEW MBA GRADUATE: Well, I’ve notthought it through that far yet.Organizational Behavior (OB) classesattempt to teach MBAs how to deal with thehuman challenges in the workplace.Quantitative skills may provide the magictheoretical pill in the classroom, but OBtries to instill in young MBA turks thehuman sensitivity to apply their MBA skillsin the real world.
  • 293. Many organizational theories are not unlikewhat you can find in books about self-awareness and sensitivity training at thelocal B. Dalton or Waldenbooks. Thereason for the similarity is that many ofthose books are written by the very sameprofessors who propound the academictheories that appear in MBA curricula. Thedifference is that faddish books about the“new” corporate rejuvenation theory or the“one-second manager” make more moneythan articles that appear in obscureacademic journals.Organizational behavior, the “touchy-feelie”subject, is often where MBAs show theirtrue colors. Sexism, prejudice, and greedrear their ugly heads in classes whenseemingly open-minded students attemptto cope with the cases at hand.
  • 294. Regardless, the classes are a welcomerelief to overworked MBAs. There is noneed for intricate quantitative analysis orextensive reading. As with other MBAsubjects, knowing the vocabulary and usingit at the right moments goes a long way inestablishing credibility on the job.What is taught in the OB classes, ifinternalized, are the lessons that well maybe the most influential in the careers ofMBAs. Without people skills, MBAs areequipped with the power tools but arewithout the electric cord to use them. The OB Problem-Solving ModelJust as marketing offers seven steps tomarketing strategy development, OBprovides a three-step technique to solve
  • 295. organizational problems.Problem DefinitionAnalysisAction PlanningProblem DefinitionThe first step to solving an organizationalproblem is to know the source of thedifficulty. Real problems are often maskedby symptoms. It is easy to be misled intosolving the symptoms instead of theircause. Unless the cause is dealt with, freshheadaches will undoubtedly arise. MBAsare taught several analytical techniques toaid in flushing out the sources of trouble.Want Got Gaps. There is a problem when agap or “deviation” exists between what a
  • 296. manager thinks “ought” to be occurring andwhat is “actually” occurring. Defining theproblem entails viewing situations from theperspectives of all the participants andoutlining their Want Got Gaps.In the wake of a failure to introduce acritical new computer technology, a largeservice organization hired a new vice-president, Hank Helpful, to lead thecomputer department out of its trouble. Inhis judgment the problem was caused byinterdepartmental rivalries. He felt that thecomputer department was isolated andalways at odds with the rest of thecompany. Hank saw the gap as follows:I Want Gap I GotInterdepartmental Cooperation GapIsolated Departmental Islands
  • 297. The VP felt that other gaps existed as well.The computer department believed itlacked the respect of the operational arm ofthe company. The people in the departmentfelt that they were being treated as second-class citizens. Both perceptions were true.But the other sales and operatingdepartments had their own gaps. Theywanted timely computer services at anaffordable cost.In many instances, organizational problemsare less easily diagnosed. Often managersdo not know exactly what the gap is. Isthere a gap at all? A manager’s perceptionscan cloud what is “actually” happening.That is often the cause of trouble in the firstplace.The Level of Problems. When you knowwhat gaps exist, it is then important to
  • 298. understand the ways in which they affectthe organization. Problems can affect acompany in three ways:- Within or between certain people- Within or between groups- Within the whole organizationIn the case of the computer departmentdescribed above, the problem existed at allthree of these levels. Each level had to beaddressed to successfully “solve” it. Thehard feelings between individuals occurredat a personal level. The interdepartmentalsquabbling was an intergroup problem. Thecompany’s failure to adopt competitive newtechnologies occurred at the organizationallevel.Source Problems and Causal Chains. Thegoal of an effective MBA is to find the mostimportant problems and solve those first.
  • 299. Those are called the source problems.Eliminate the source, eliminate thesymptoms. Source problems, such as thelack of respect for the computerdepartment, caused a multitude of otherproblems.A graphical method used to get at sourceproblems is to draw a causal chain. Using acausal chain, the company’sinterdepartmental problem would look likethis:Contributing Problems Source ProblemBusiness ProblemLack of Interaction: Personality DifferencesLack of Respect for Techies ProjectFailures
  • 300. AnalysisAfter defining the gaps and using causalchains, the MBA is taught to link theproblems to their causes. In addition todrawing causal chains, during thisanalytical step you try to understand thecauses. Why do they exist? Whatenvironmental factors play a role? Byasking these types of questions you canbegin to confront which causes can becorrected through management action. Ifone problem is insurmountable, differentsolutions have to be tried. In the exampleabove, firing uncooperative people was anoption for the vice-president. Sensitivitytraining and interdepartmental discussionswere other possibilities. As in a marketingplan, there are many possible avenues foraction available to achieve a successful
  • 301. resolution to a problem.Action PlanningMBAs are taught to be decisive andproactive—a frequently used MBAadjective. After a thorough analysis, MBAsshould be able to formulate a plan. Theaction plan has six important steps.1.Set Specific Goals.2.Define Activities, Resources Needed, Responsibilities.3.Set a Timetable for Action.4.Forecast Outcomes, Develop Contingencies.5.Formulate a Detailed Plan of Action in Time Sequence.6.Implement, Supervise Execution, and Evaluate Based on Goals in Step One.
  • 302. As you can imagine, solving problemsMBA-style is not simple. It requires timeand effort. To add to your MBA vocabulary,you should refer to your menu of possibleactions as action levers. This sounds veryforceful and progressive. An action levermay be a reward, a control, or a planningsystem.The idea behind OB is to train MBAs toavoid tactical errors because they failed totake into consideration the people involved.With a framework to tackle challenges, theMBA curriculum inculcates in its studentsthe theories and methods of the day so thatthey can use them.Individual and Organizational Level OB Topics
  • 303. The previous discussion covered theframeworks used to analyze a problem andimplement a solution. The next sectionsdeal with the topics that provide thebackground for that process. The MBAcurriculum logically starts with the theoriesand topics that deal with the individual, thenbuilds to larger organizational issues thatbecome progressively complex with theaddition of more people. Along the way,students are asked to apply their newlyacquired skills to analyze and plansolutions to increasingly complex andchallenging case situations.The MBA Psychology Lesson: The APCFBModelIn the effort to gain an insight into whypeople act the way they do at work, theMBA curriculum includes some form of the
  • 304. APCFB model pictured here. This modelattempts to explain the cognitive process oflinking external events to employeebehavior. Assumptions affect theperceptions people have. Thoseperceptions affect the conclusions. Andthose conclusions prompt feelings.Ultimately those feelings drive behaviorsthat managers observe. By trying tounderstand this process, MBAs may have achance to influence positive behaviors inthemselves as well as in their co-workers.The model looks like this:The APCFB Psychology Model
  • 305. “Why People Behave the Way They Do,”Case UVA-OB-183, Figure 5. Copyright ©
  • 306. 1986 by the Darden Graduate BusinessSchool Foundation, Charlottesville, Virginia.Given an analytical tool, MBAs are made tobelieve that they can understand anything.However, confounding forces within peopleprevent perfect communication andunderstanding. We all see through filtersthat often prevent us from perceivingevents accurately. Filters also prevent usfrom acting out our true desires. We allhave internal defense mechanisms that actas additional filters to protect us frompsychological damage. They also preventan accurate psychological reading of otherpeople. For example, if an insecuresupervisor has a poor aptitude for numbers,then by way of defense, he may find faultwith an analyst’s technical presentation.That would help him avoid confronting his
  • 307. own ineptitude with numbers.MBAs have a chance to affect assumptions, the beliefs we hold about the way theworld or other people or ourselves shouldor ought to be. These assumptions makeup our value system. Listed in order ofease of accessibility, assumptions include:ExpectationsBeliefsValuesExpectations and to some extent beliefscan be changed through clear managementintent and action. Values are deeply heldassumptions that may be altered, if at all,only in time.
  • 308. When a manager is able to tap into thevalues of subordinates, then realproductivity may result. Personally, I placea high value on creativity and freedom.When my manager taps into that well insideme, he elicits my best work. For example,when my boss seeks an insightfulmarketing analysis, he presents me with anopportunity to express my creativity. Ourgoals are said to be congruent orequivalent because we are both aiming atthe same thing. The desired behavior isproduced. Goal congruence among theindividuals of an organization makes thegroup productive. “Goal congruence” is apopular MBA phrase—it sounds great, andit is in fact meaningful.Let’s take the example of a strategicplanning manager. He wanted to tap his
  • 309. team’s creativity in developing plans tocompete in an evolving marketplace. In thepast, he had done all the creative workhimself. His staff members were simplyused to crunch numbers. To elicit a changein their behavior, he had to learn to toleratethe trial and error that are part of thecreative process. Because staff failures inthe past had been met with firings andridicule, the team understandably would beslow to comply with his wishes. The staff’sassumptions stood in the way. To effect thedesired change, he needed to build trust byrewarding creative behavior on a consistentbasis.The bottom line is that understanding a bitof psychology is useful if you wish tomotivate people.
  • 310. Expectancy Theory of MotivationMotivation is an elusive animal that allorganizations want to capture. Expectancytheory outlines the factors that producemotivation with individuals. Managers, staff,and even you can use expectancy theory toattempt to understand employees’behavior.Motivation = Expectation of Work will leadto Performance × Expectation Performancewill lead to Reward × Value of RewardThis equation may be helpful in isolatingthe source of a problem. Each of theequation’s components can explain someaspect of motivation. If a marketingmanager of a declining make of automobile
  • 311. has been losing market share to a better-manufactured and better-promotedcompetitor, he might feel that no matterwhat he does he will fail. That naturallywould decrease his motivation. If thecompany never rewarded superiorperformance, that would also lead todiscontent. And finally, if the reward weresimply a set of keys to the executivewashroom, then a manager might think ofworking elsewhere.Three academic heavyweights, Hertzberg,Maslow, and McClelland, believe thatbehavior is motivated by the urge to satisfyneeds. Fred Hertzberg posits thatmotivation will be enhanced by maximizingthe motivators or satisfiers on the job andminimizing the dissatisfiers or maintenancefactors. A promotion or an award can be a
  • 312. satisfier. Maintenance factors don’tnecessarily bring happiness, but they areexpected. A safe place to work and a livingwage are typical maintenance factors.Abraham Maslow sees employeemotivation as a function of meeting anemployee’s hierarchy of needs. Thehierarchy is frequently depicted as apyramid. The need for food and water is atthe bottom of the pyramid, followed by theneed for safety, the need to belong, and theneed for status, while self-actualizationneeds are seen as the highest order ofneeds. These needs are met when aperson experiences a sense of personalgrowth and self-fulfillment by accomplishinga challenging goal.Finally, David McClelland proposes thatpeople have three basic needs, the need
  • 313. for achievement, the need for power, andthe need for affiliation. Whatever thetheory, managers must recognize theneeds of employees.Job DesignAnother way to understand and affectemployee motivation is to investigate theway a job is designed. Each job has certaincore job dimensions that describe theduties performed. These duties lead tocritical psychological states withinemployees that result in a variety ofoutcomes. Outcomes are the visiblemanifestations of work performance, whilepsychological states are hidden in thehearts and minds of people. If the humanelement is ignored, then quality andefficiency will suffer.
  • 314. If the MBA is confronted with a personnelproblem, it may be the result of job design.A close study of the core job dimensionscan often yield great benefits withoutsignificant costs. For example, at aLockheed parts factory in Los Angeles,unskilled minorities were hired and trainedto assemble parts for jumbo jets fabricatedat another factory. The employees wereunmotivated and the quality of their outputwas poor. In talking with the men workers,the managers realized that the work had nomeaning to them. They did not understandwhat they were producing. To fix that theworkers were taken to the aircraft assemblyplant to see where their parts wereinstalled. They also met those who wereinconvenienced when they received adefective product. Realizing the relevanceof their work, the employees became more
  • 315. productive and part defects decreased.Their previously pointless assembly taskacquired significance, and they respondedby performing better. The end result was ahappier work force that took pride in a jobwell done. The MBA term for suchemployee happiness is quality of work life(QWL). When employees are given thechance to be all that they can be, the wordMBAs use to describe this is empowerment. You can hardly pick up a business booktoday without tripping over that word.Job Design Model
  • 316. Adapted from “Introduction to Job Design,”by Professor William Zierden, Case UVA-OB-91R, Figure 1. Copyright © 1975 by theDarden Graduate Business SchoolFoundation, Charlottesville, Virginia.MBA Personality TraitsBusiness schools teach young women andmen business skills, but they also try to
  • 317. motivate their students to maximize theirown potential. In that vein, MBAs are taughtto be innovative leaders.Leadership. The top MBA schools claim tobe incubators for the business leaders oftomorrow. In this pursuit organizationalbehavior classes probe the subject ofleadership and its responsibilities. Someschools even send their students to thewoods for Outward Bound experiences tounleash the leaders inside them anddevelop team skills. Leaders shape goals.Leaders develop new ideas. Leaders reachpeople on an emotional level. Managers,on the other hand, react to events.Managers solve problems, while leaderstake on challenges. Of course, at the topbusiness schools, everyone fancies himselfor herself as a future captain of industry.
  • 318. The Leadership VCM Model. The VCMleadership model proposes that thefollowing three characteristics are part of aleader’s personal profile:- Vision- Commitment- Management SkillsLeaders exhibit these qualities in differingproportions. No particular mix works best. Itall depends on the individual and the jobsituation. Lee Iacocca could be viewed asbeing high on vision when he saw thepotential for the Ford Mustang in the 1960s.He also saw hope for Chrysler in its darkdays in the late 1970s. In the accountingprofession vision is not as critical, whereasmanagement skills and commitment to longhours are the keys to success.
  • 319. Leadership Patterns. There are as manyways to lead the troops as there arepeople. Leadership styles lie on a spectrumfrom boss-centered to subordinate-centered. In the 1960s executives raced tobe tested to see where they fell on thespectrum. Based on a managerial grid, theycould be classified a “dictator” or a “wimp.”Some bosses use their authority directly topress their people into action. They do thethinking, and the staff does the legwork.Others give their people the freedom to usetheir own wits to organize and accomplishtasks. The boss’s function is to give generaldirection.Leadership Styles Vision, Commitment,and Management
  • 320. Adapted from “Survey of Managerial Style,”by Professor James Clawson, Case UVA-OB-358, p. 14. Copyright © 1988 by theDarden Graduate Business SchoolFoundation, Charlottesville, Virginia.Which leadership style a leader chooses isregulated by three basic forces:- The forces within the manager- The forces within the subordinates- The forces of the situationIf the leaders do not have confidence intheir subordinates, they cannot delegate
  • 321. tasks. If a staff doesn’t have the ability towork unsupervised, full delegation ofauthority is inappropriate. When the staffhas a clear understanding of the businesssituation and how to address it, it’s best todelegate authority.It is very important for a leader tounderstand his or her own personalitytraits. As you might imagine, a leader’sinsecurities may lead to an authoritarianstyle, regardless of what the situation maydictate. That is why self-awareness isimportant; it will enable you to avoidinappropriate management styles.My faults and my virtues are thesame…Nothing is ever enough. I mustcheck everything. It causes meproblems—people think I don’t trustanyone. But I must know what’s going on.
  • 322. —Giorgio Armani, Forbes, October 28,1991Creativity. Not only are MBAs schooled tounderstand leadership, they are taught tobecome leaders by tapping their owncreativity. Because vision is an element inthe VCM pie, MBAs ought to nurture theirown creativity. Everyone has idea-friendlytimes when they are most creative. Forsome it may be while in the shower, forothers on the porcelain throne or in the car.Creative thought is often very fleeting; youmust be able to capture it in its tender,nascent stage. What a Great Idea by ChickThompson suggests that we should alwayskeep a pen, a tape recorder, or a greasepencil (for the shower) handy in each of ourfriendly places.
  • 323. The mind-mapping technique is alsoavailable. Take a blank piece of paper andstart thinking about a creative challenge,then write down the subject and circle it.Proceed, in a completely uninhibited style,to scribble and circle all your relatedthoughts around that subject’s key wordsand connect them like the spokes on awheel. Each of the spokes should havespokes around it, and so on. No thought istoo stupid! After it’s all done, somethingmay emerge from the jumble of freeassociation. I’ve used the technique to thinkup titles, promotional copy, and projectsolutions for this book. Try it—you havenothing to lose.An abbreviated mind-mapping session todevelop the name for this book looked likethe diagram at right.
  • 324. Type A and B Behaviors. OB professorshave introduced the concept of behaviortyping into the curriculum as an added toolfor personal understanding. Since mostMBAs attending the Top Ten schools wereadmitted because their Type Apersonalities helped them to the top of theircollege classes, it seems appropriate thatthey should understand that aspect ofthemselves. Type A behavior was originallyidentified in 1959 by two cardiologists,Meyer Friedman and Ray Roseman. Theynoticed that patients with severe coronaryheart disease were often characterized bythe following traits.Mind Mapping for a Book Title
  • 325. - A Competitive Need for Achievement- A Sense of Time Urgency- Aggressiveness- Hostility to Others and the WorldAdditional manifestations of Type Abehavior include explosive, acceleratedspeech, interruption of others, a fast-pacedapproach to life, and impatience. Type A’salways try to do more than one activity atonce. That’s what those Day-Timer plannerbooks are for. Type A’s are oftendissatisfied with life, showing a free-floatinghostility. They evaluate their self-worthbased on external achievements. One suresymptom is competition with others innoncompetitive situations. A classmatereported such a case: “During the interviewseason I was struck by a pizza companyexecutive who boasted that his
  • 326. performance on the treadmill, during thecompany’s annual physical, was superior tothat of his co-workers.” That executive wasa Type A.On the opposite side of the spectrum, thereare the Type B’s who enjoy life and aremore relaxed. Some Type B’s also sneakinto business schools. Most individuals fallin the continuum between the two poles.Hopefully, by recognizing the Type A signs,MBA hard chargers may be able to head offa heart attack by exercising some controlover their behavior. If not, behavior typingcan make good bar conversation for MBAsheading for coronary oblivion.MBA Office ProceduresThe OB faculty, besides making studentsaware of their potential and shortcomings,tried to teach us some practical
  • 327. interpersonal skills that would help us tosucceed on the job.Active Listening. One of the most valuableskills is to be able to really listen. Activelistening helps you to gain a clearperception of situations so that you caneffectively deal with them. It differs fromconversation in three ways:- You Respond to Information and Don’t Lead.- You Respond to Personal Information and Don’t Give Advice.- You Identify the Interviewee’s Feelings as Well as the Content.An active listener cedes control of theconversation to the other party. Givenenough leeway, true motivations, feelings,and beliefs can come forth. After the active
  • 328. listening session runs its course, you canstart to talk and act like an MBA know-it-allagain.Performance Appraisals. One of the mostmismanaged tools for organizationalimprovement is the performance appraisal.Rating forms are sometimes used veryeffectively for timely feedback and personaldevelopment. However, most of the time itis a task that is delayed until the appraisalreally has lost all usefulness. Effectiveappraisals ought to have three types ofgoals:OrganizationalFeedback and EvaluationCoaching and Development
  • 329. Organizational goals aim to ensure properconduct and levels of performance,placement, promotion, and pay. Thefeedback and evaluation aspects provideboth employees and employers with aformal process and documentation ofperformance. Coaching and developmentshould ultimately be the primary goals of anappraisal. How can we improve, rather thanpunish, unsatisfactory performance?Working together, the boss and thesubordinate should agree on specifictargets and timetables for improvement.These plans for the future lay thegroundwork for a follow-up.The problem is that managers tend to avoidthis evaluation process. Subordinates aredefensive. The appraisal must be timely;
  • 330. both participants must be prepared. Theboss should foster an open climate of realcommunication (both ways) and make thepurpose of the appraisal clear. As simpleas the appraisal can be, it is seldom doneright.In addition to the potential for improvement,appraisals provide employers thedocumentation to legally fire an employee.Without documentation a disgruntledworker could sue the company for lack ofjust cause.Reprimands. Sometimes an MBA will becalled on to lower the boom. In line with myclass discussions, the MBA shouldreprimand a subordinate using the followingfour steps.
  • 331. 1.Check out the facts first. Ask yourself if you caused the problem.2.Give warning that you need to talk about the problem.3.Pause and express your displeasure. Tell it exactly as you see it. Yelling is counterproductive.4.Display a caring attitude. “I did not approve of your behavior, but you are still okay.” “Let’s learn from this and put it behind us.” The idea is to do it firmly, clearly, and move on to new business.“A good manager can balance hisreprimands with praise.”Managing Your Boss. MBAs are not alwaysbosses. Most start out as lowly analysts,planners, and associates. Ironically, these
  • 332. are the positions that operations classescharacterize as corporate fat, ripe fortrimming. Even if MBAs find themselves inmore senior managerial jobs, it’s a safe betthat they will have a boss to deal with. Evenpresidents have to deal with chairmen!Management of the relationship upward isas important as managing your relationshipbelow. That’s why I’ve included it in thisbook. To give the MBA an edge, thecurriculum includes a session on how tomanage your boss. “Managing Your Boss”appeared in the Harvard Business Reviewin January 1980. It was written by JohnGabarro and John Kotter and it capturesthe subject well.“The first step to success on the job is tounderstand bosses and their context,including:
  • 333. - Their stated and unstated goals and objectives- The pressures on them- Their strengths, weaknesses, blind spots- Their preferred work styles“The second step is to be introspective andassess yourself and your needs, including:- Your own strengths and weaknesses- Your personal style- Your predisposition toward dependence on or resistance to authority figures“The third step is to incorporate the first twosteps and develop and maintain arelationship that:- Fits both your needs and styles- Is characterized by mutual expectations- Keeps your boss informed—bosses hate surprises!
  • 334. - Is based on dependability and honesty- Selectively uses your boss’s time and resources” *Simply by asking a few questions at thestart of the relationship, you can avoidmaking major political blunders in thefuture. Some bosses like a formalrelationship, memos, and meetings withagendas. Others prefer informal notes andfrequent unstructured meetings. SmartMBAs take the initiative to ask their bosseshow they would prefer to communicaterather than guess. Careers often hang inthe balance. I still keep Gabarro andKotter’s article at my desk as a reminder tomanage my boss.Understanding Power on the Job. If MBAswant power, then they ought to know more
  • 335. about what they seek. There are actuallyfive types of power:CoerciveRewardReferentLegitimateExpertCoercive power is based on fear. Failure tocomply with a request could result in someform of punishment. A person with coercivepower can influence or directly fire, demote,or transfer an employee. At a firehouse, thechief has the power to assign shifts. If youget on the chief’s bad side, it could meanyou work holidays.
  • 336. Reward power is based upon theexpectation of receiving praise, recognition,or income. It’s the opposite of coercivepower.Referent power is derived from being aperson whom other people admireregardless of formal job status. Thesepeople are said to have charisma to inspireand to attract followers. Star salespeoplehave this role in sales organizations.Legitimate power is due to the formal statusheld in the organizational hierarchy. Thosewith this type of power can use it to reward,to ax, and to influence the lives of others inthe organization. A shift foreman has thepower to assign duties on an assembly line.Expert power comes from one’s own skill,knowledge, or experience. People withexpert power have the ability to manipulate
  • 337. others. This is without regard to theirposition in the company. Often it is a lowlycomputer technicia