Core Management Concepts (UOL Subject guide)

Core management concepts
P. Willman
MN2177
2014
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 200 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 5 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:
Professor Paul Willman, Department of Management, London School of Economics and
Political Science.
This is one of a series of subject guides published by the University.We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
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Published by: University of London
© University of London 2014
The University of London asserts copyright over all material in this subject guide except where
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us know.

Contents
i
Contents
Chapter 1: Introduction........................................................................................... 1
1.1 Introduction to the subject........................................................................................1
1.2 Route map to the guide............................................................................................1
1.3 Syllabus....................................................................................................................2
1.4 Aims of the course....................................................................................................2
1.5 Learning outcomes for the course............................................................................. 2
1.6 Overview of learning resources.................................................................................2
1.7 Examination advice..................................................................................................5
Chapter 2: Management and the firm..................................................................... 7
2.1 Learning outcomes and reading................................................................................ 7
2.2 Introduction.............................................................................................................8
2.3 The British experience...............................................................................................8
2.4 Railways and the second Industrial Revolution.......................................................... 9
2.5 Market failure and management............................................................................. 10
2.6 Transaction cost economics.....................................................................................12
2.7 Overview of chapter ..............................................................................................14
2.8 Reminder of learning outcomes..............................................................................15
2.9 Test your knowledge and understanding................................................................. 15
Chapter 3: Taylorism, motivation and performance.............................................. 17
3.1 Learning outcomes and reading.............................................................................. 17
3.2 Introduction...........................................................................................................18
3.3 Scientific management: the apogee......................................................................... 21
3.4 Engineering and psychology....................................................................................23
3.5 Overview of chapter...............................................................................................25
Chapter 4: The rise and decline of labour............................................................. 27
4.2 Introduction...........................................................................................................28
4.3 Farmers and workers..............................................................................................29
4.4 Band of brothers....................................................................................................30
Chapter 5: The rise of human resource management........................................... 37
5.2 Introduction...........................................................................................................38
5.3 The emergence of HRM...........................................................................................39
5.4 Organisational behaviour........................................................................................44
5.5 The psychological contract......................................................................................46

MN2177 Core management concepts
ii
Chapter 6: The origins of management science.................................................... 49
6.2 Introduction...........................................................................................................49
6.3 Inventory management...........................................................................................50
6.4 Telephone networks................................................................................................52
6.5 Military planning....................................................................................................53
Chapter 7: Accounting, finance and the firm......................................................... 57
7.2 Background: definitions of accounting and finance.................................................. 58
7.3 Principal–agent theory............................................................................................58
7.4 The institutional environments of accounting .......................................................... 61
Chapter 8: Management accounting: costing....................................................... 65
8.2 Purposes of cost accounting...................................................................................65
8.3 Production and service departments........................................................................ 66
8.4 Activity-based costing ............................................................................................69
8.5 Overview of chapter ..............................................................................................71
Chapter 9: Management accounting: decentralisation and performance
measurement ........................................................................................................ 73
9.2 Introduction...........................................................................................................74
9.3 History...................................................................................................................74
9.4 Using return on investment (ROI)............................................................................ 76
9.5 The balanced scorecard...........................................................................................78
9.6 Financial (ROI) versus balanced scorecard performance measure ............................ 80
Chapter 10: Financial accounting.......................................................................... 83
10.1 Learning outcomes and reading............................................................................ 83
10.2 Management accounting and financial accounting................................................ 83
10.3 The elements of the financial report...................................................................... 84
10.4 Recognition and matching ...................................................................................89
10.5 Overview of chapter.............................................................................................90
10.6 Reminder of learning outcomes............................................................................ 90
10.7 Test your knowledge and understanding............................................................... 90
Chapter 11: Modern portfolio theory.................................................................... 91
11.2 Interest rates and the time value of money............................................................ 91
11.3 The return of a single security...............................................................................92
11.4 The return of a portfolio........................................................................................92
11.5 Probabilistic considerations...................................................................................92

Contents
iii
11.6 Asset classes........................................................................................................93
11.7 What is a hedge fund?..........................................................................................94
11.8 What is private equity?.........................................................................................94
11.9 Market efficiency..................................................................................................94
11.10 Optimal portfolio choice.....................................................................................95
11.11 The Sharpe ratio.................................................................................................97
11.12 Overview of chapter...........................................................................................97
11.13 Reminder of learning outcomes.......................................................................... 97
11.14 Test your knowledge and understanding............................................................. 97
Chapter 12: Security analysis and valuation......................................................... 99
12.2 Financial ratios.....................................................................................................99
12.3 Investment ratios..................................................................................................99
12.4 Profitability ratios...............................................................................................100
12.5 The profitability equation....................................................................................101
12.6 Margin ratios......................................................................................................101
12.7 Efficiency ratios..................................................................................................102
12.8 Leverage ratios...................................................................................................102
12.9 Solvency and liquidity ratios................................................................................103
12.10 Overview of chapter.........................................................................................103
12.11 Reminder of learning outcomes........................................................................ 104
12.12 Test your knowledge and understanding........................................................... 104
Chapter 13: The origins of modern strategy....................................................... 105
13.1 Learning outcomes and reading.......................................................................... 105
13.2 Two key definitions of ‘strategy’.......................................................................... 105
13.3 Porter and the five forces....................................................................................107
Chapter 14: Understanding organisational structures........................................ 113
14.2 Introduction.......................................................................................................113
14.3 Organisational design.........................................................................................114
14.4 Organisational boundaries: the issues................................................................. 115
14.5 Division of labour: the issues...............................................................................116
14.6 Authority and communication: the issues............................................................ 116
14.7 Bureaucracy: the issues.......................................................................................117
14.8 Know-how: the issues.........................................................................................117
14.9 The components of organisation......................................................................... 118
14.10 The ‘M’ form.....................................................................................................119
14.11 Overview of chapter.........................................................................................121
Chapter 15: The analysis of organisations.......................................................... 123
15.2 Strategy and organisational theory...................................................................... 123
15.3 Institutional theory.............................................................................................125
15.4 Organisational ecology.......................................................................................127
15.5 Critique..............................................................................................................128
15.6 Organisational sociology and economics............................................................. 129

iv
Chapter 16: Contemporary strategic management............................................. 131
16.2 Introduction.......................................................................................................132
16.3 Dynamic capabilities...........................................................................................135
16.4 Core competences..............................................................................................135
16.5 Critique..............................................................................................................136
16.6 Strategy today....................................................................................................137
16.7 Overview of the chapter......................................................................................137
Chapter 17: Strategy and decision-making ........................................................ 139
17.2 Introduction.......................................................................................................139
17.3 Efficient markets.................................................................................................142
17.4 The decision process...........................................................................................144
17.5 Overview of the chapter......................................................................................146
Chapter 18: The origins of marketing................................................................. 149
18.2 Introduction ......................................................................................................149
18.3 Definitions and a brief introduction to the history of marketing as a
distinct ‘discipline’ of study ........................................................................................150
18.4 Marketing and economic theory.......................................................................... 150
18.5 Where does economic theory leave us? .............................................................. 152
18.6 Marketing as ‘academic discipline’ ..................................................................... 152
18.7 The influence of other academic disciplines and marketing ................................. 153
18.8 Types of marketing problems ..............................................................................153
18.9 The triumph of marketing? .................................................................................154
18.10 Looking ahead: the marketing framework ........................................................ 155
18.11 Overview of the chapter....................................................................................156
Chapter 19: The origins of marketing − the development of the practice ........ 159
19.2 Introduction.......................................................................................................159
19.3 Product1...............................................................................................................................................................................................160
19.4 Markets..............................................................................................................161
19.5 Pricing................................................................................................................162
19.6 Channels and distribution...................................................................................164
19.7 Brands and advertising.......................................................................................165
19.8 Summary............................................................................................................167

Contents
v
Chapter 20: Marketing in the digital age............................................................ 169
20.2 Introduction.......................................................................................................170
20.3 Impact on conventional businesses..................................................................... 172
20.4 Internet and branding.........................................................................................174
20.5 Summary............................................................................................................174
Appendix 1: Syllabus........................................................................................... 177

Notes
vi

Chapter 1: Introduction
1
1.1 Introduction to the subject
This subject guide is for the MN2177 Core management concepts
course. It covers the main areas of general management and the
intellectual foundations of management concepts as well as the functional
areas of accounting, business strategy, finance, marketing, organisational
behaviour and operations management. This is an alphabetical list, but
each subject will be dealt with in an integrated fashion. The aim is to
present the core concepts in each area, then to show the relationships
between these concepts. This course forms the basis for the study of more
specialised courses.
The course begins by showing how these functional areas emerged as
subjects for academic study. It will pay particular attention to the social
scientific origins of the management field in the core disciplines of
economics, psychology and sociology. It then proceeds chronologically,
illustrating the rise and development of the functional area disciplines in
response to specific business problems.
1.2 Route map to the guide
We begin by looking at the pre-industrial roots of some management
tools such as accounting and operations. It then deals specifically with the
growth of the large industrial firm and the intellectual issues raised by this
development. It describes the separation of ownership and control and
the problems of agency. Several chapters deal with the issues of creating
and managing an industrial labour force, looking at scientific management
and the growth of theories rooted in psychology and sociology for the
management of labour. The rise of collective labour organisation and the
response of human resource management is then covered.
The second broad section of the course is more quantitative, showing how
mathematical techniques were applied to the management of the firm. We
then move on to consider, first, the rise of internal accounting measures in
the firm and, second, financial accounting, particularly the firm’s reporting
requirements. There is then a specific focus on the increasingly important
area of finance; we look at risk, return and asset pricing, before turning to
the financial analysis of the firm. These materials are presented in a non-
technical way wherever possible.
The third broad theme is organisation and strategy; looking at the origins
of business strategy and the various ‘schools’ within the strategy discipline.
We pay particular attention to contemporary developments in business
strategy and to strategic decision-making.
Finally, we look at the marketing field. The location of this at the end
of the course has a two-part rationale. First, marketing was a later
development than some other disciplines and it is possible to show
how ideas were borrowed and used. Second, it synthesises economics,
psychology and sociology and thus is a good ‘case study’ of the use of
social science in management.

2
1.3 Syllabus
The full syllabus for this course can be found in Appendix 1 on p.177 at
the end of the guide.
1.4 Aims of the course
The aims of the course are to:
• give you a thorough grounding in the key management sub-disciplines
• provide an overview of the development of these disciplines
• illustrate the disciplinary anchors of these disciplines in sociology,
psychology and economics.
1.5 Learning outcomes for the course
At the end of the course, and having completed the Essential reading and
activities, you should be able to:
• demonstrate an understanding of core management concepts
• apply these concepts to specific business situations
• analyse and evaluate managerial tools such as balance sheets and
marketing plans
• explain the relevance of social science to business practice.
1.6 Overview of learning resources
1.6.1 The subject guide
This subject guide presents a basic introduction to the concepts of
management covered in the course. It seeks to describe and explain
the central concepts, and to provide reading lists and advice on the
examination. However:
1. It is not a textbook and often refers you to other texts or readings.
2. If you do not follow up the Essential readings, you will find it very
difficult to do well in the examination.
For each chapter, we recommend that you begin by reading the text of the
guide itself and thinking about the ‘Test your knowledge and understanding’
question at the end of each chapter, then work through the Essential
readings outlined at the start of the chapter. Further reading is identified
should you wish to study a topic in more detail, and a comprehensive list
can be found on the virtual learning environment (VLE).
The advice normally given to International Programmes students is that,
if they are studying one course over a year, they should allow at least six
hours of study every week.
1.6.2 Essential reading
To study this course, you need to study Essential readings from a range of
textbooks and academic journals.
Textbooks to borrow or purchase
Make sure you have a copy of the core textbook for the course:
Willman, P. Understanding management: social science foundations. (Oxford:
Oxford University Press, 2014) [ISBN 9780198716921].

3
This will be referred to as ‘Willman’ in the reading lists at the beginning of
each chapter, followed by the relevant chapter or theme numbers.
You will also need to refer to several chapters of the following book so
either make sure that you have access to a library copy or purchase it:
Kaplan, R. and A. Atkinson Advanced management accounting. (Harlow: Pearson
Education, 1998) third edition [ISBN 9780130802200].
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
Other Essential readings
The guide also refers to various other Essential readings. We aim to ensure
that all these are freely available to you. As a general rule, if an Essential
reading is a journal article, you will be able to find it in the Online Library;
if it is an extract from a book, registered students on the course will be
able to download it from the VLE. We have also made a few of the further
readings available to download from the VLE.
If you have any problems accessing any of the Essential readings, let us
know by raising a query via the Student Portal.
1.6.3 Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
A list of Further readings relevant to the subject matter covered in each
chapter is given at the beginning of the chapters. You can find a complete
list of all the Further reading and references cited on the VLE.
You may also find the following additional textbooks useful in relation to
the different parts of the course:
Additional introductory reading
Witzel, M. Builders and dreamers: the making and meaning of management.
(Harlow: Pearson, 2002) [ISBN 9780273654377].
Accounting
Atkinson, A.A., R.S. Kaplan, E. Matsumura and S.M. Young Management
accounting. (Harlow: Pearson, 2011) [ISBN 9780273760160].
Business strategy
Grant, R.M. Contemporary strategy analysis. (Chichester: John Wiley & Sons,
2012) [ISBN 9781119941880].
Finance
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance – global
edition. (Maidenhead: McGraw Hill, 2013) [ISBN 9780077151560].
Marketing
Weitz, B.A. and R. Wensley Handbook of marketing. (London: Sage, 2006)
[ISBN 9781412921206].

4
Operations management
Hopp, W.J. and M.L. Spearman Factory physics. (Long Grove, Illinois: Waveland
Press, 2011 reissue of 2008 edition) [ISBN 9781577667391].
Organisational behaviour
Buchanan, D. and A. Huczynski Organisational behaviour. (Harlow: Pearson,
2013) [ISBN 9780273774815].
1.6.4 Online study resources
In addition to the subject guide, it is crucial that you take advantage of the
study resources that are available online for this course, including the VLE
and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on
your application form. You have probably already logged in to the Student
Portal in order to register. As soon as you registered, you will automatically
have been granted access to the VLE, Online Library and your fully
functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.

5
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
1.7 Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination will be a three-hour unseen written examination covering
all aspects of the syllabus. In the examination, you will be asked to:
• Reproduce some knowledge. This will get you close to a pass, but you
will also need to be able to apply this knowledge to the question.
• Apply knowledge to new situations. This will lift you to high lower-second
or low upper-second marks, provided you get the questions right.
• Make new connections between topics and concepts. This will enable
you to gain a first-class mark.
In the examination you must read the questions carefully to make sure you
have understood them, choose the questions you wish to answer from the
list available and manage your time carefully. You should always check the
instructions on the examination paper before you begin and follow them
carefully.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course, which give advice on how each question might best be
answered.

Notes
6

Chapter 2: Management and the firm
7
2.1 Learning outcomes and reading
2.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
• explain key elements in the history of the firm
• discuss the main theories of firm formation
• outline several key managerial problems in the firm.
Willman, Chapters 1 and 2.
Chandler, A. The visible hand: the managerial revolution in American business.
(Harvard: Harvard University Press, 1977) [ISBN 9780674940529].
Di Maggio, P. ‘Introduction: making sense of the contemporary firm and
prefiguring its future’ in Di Maggio, P. (ed.) The twenty-first century firm:
changing organisation in international perspective. (Princeton: Princeton
University Press, 2001) [ISBN 9781400828302].
Jensen, M.C. and W.H. Meckling ‘The theory of the firm: managerial behaviour,
agency costs and ownership structure’, Journal of Financial Economies 3
1976, pp.305–60.
Williamson, O.E. ‘The modern corporation; origin, evolution, attributes’,
Journal of Economic Literature 19 1981, pp.1537–68.
2.1.4 Works cited
Arrow, K. J. The limits of organization. (New York: Norton, 1974)
[ISBN 9780393093230].
Bromiley, P. The behavioral foundations of strategic management. (Oxford,
Blackwell, 2005) [ISBN 9781405124706].
Cassis, Y. ‘Big business’ in Jones, G. and Zeitlin, J. (eds) The Oxford
handbook of business history. (Oxford: Oxford University Press, 2007)
[ISBN 9780199263684; 9780199573950], p171–94.
Coase, R.H. ‘The nature of the firm’, Economica, 4(16), 1937, pp.386–405.
Coase, R.H. The firm, the market and the law. (Chicago, Ill: University of
Chicago Press, 1988) [ISBN 9780226111001].
Davis, G. Managed by the markets. (Oxford: Oxford University Press, 2009)
[ISBN 9780199216611].
Doeringer, P. and M. Piore Internal labour markets and manpower analysis.
(Armonk, NY: M.E. Sharpe, [1971] 1985) [ISBN 9780873323321].
Ghoshal, S. and P. Moran ‘Bad for practice: a critique of the transaction cost
theory’, Academy of Management Review 21(1) 1996, pp.13–47.
Gospel, H. ‘The management of labor and human resources’ in Jones, G. and
Zeitlin, J. (eds) The Oxford handbook of business history. (Oxford: Oxford
University Press, 2007) [ISBN 9780199573950], pp.420–46.
Landes, D.S. The Unbound Prometheus: Technological Change and Industrial
Development in Western Europe from 1750 to the Present. (Cambridge:
Cambridge University Press, 2003) [ISBN 9780521534024].
Michie, R.C. The global securities market. (Oxford: Oxford University Press,
2006) [ISBN 9780199280612].
Penrose, E. The theory of the growth of the firm. (Oxford: Oxford University
Press, [1959] 2009) [ISBN 9780191570360].

8
Pfeffer, J. New directions for organisational theory. (Oxford: Oxford University
Press, 1997) [ISBN 9780195114348].
Prais, S.J. The evolution of giant firms in Britain. (Cambridge: Cambridge
Salaman, G. Class and the corporation. (London: Fontana, 1981)
[ISBN 9780006355182].
Thompson, E.P. The making of the English working class. (London: Penguin,
1966) [ISBN 9780394703220].
Williamson, O.E. The economic institutions of capitalism. (New York: Free Press,
1985) [ISBN 9780684863740].
2.2 Introduction
The corporate firm is a rather late arrival on the scene. Before the 19th
century, only a handful of corporate-type entities existed and these
were largely extensions of state power. Companies such as the Hudson
Bay Company or the Dutch East India Company were important agents
of empire. Governments granted them exclusive rights to trade and
to conduct business in certain markets or products. So, for example,
in 1670 the Hudson Bay Company was granted exclusive rights to fur
trapping in large areas of Canada by the British government. It was a truly
international venture, being the idea of two Frenchmen who gained a
Royal Charter in Britain with the encouragement of Boston merchants. The
company built forts, extended the speaking of English, founded cities and
established distribution channels. The Hudson Bay Company still exists in
Canada as a chain of department stores. At its inception, the company had
32 investors who shared risks and returns.
The Dutch East India Company, founded earlier, in 1602, funded risky
long-distance trading in any items between Europe and the Far East.
Investors, primarily in Amsterdam, would pool funds to support risky
trips which, if successful, provided huge returns. This in turn prompted
the development of the Amsterdam securities market in which spot and
future contracts, call and put options, hedging and short selling were all
possible (Michie, 2006, p.27). The number of investors was very large
indeed. These entities have some important characteristics for the future
analysis of the firm. Investors control supply side risk (with monopoly)
before sharing investor risk, they get government to provide the support,
and they diversify away some operational risk by embracing a range of
uncorrelated activities.
2.3 The British experience
The Industrial Revolution took off in Britain in the early 19th century and,
as Michie notes, in the period before 1850, ‘The British economy remained
mostly untouched by joint stock enterprise’ (2006, p.69). Enterprises
were either entrepreneurially owned, as in manufacturing, or owned by
local inhabitants, as in utilities and canals, and were funded by retained
profit or bank loans. Railways changed everything, requiring large-scale
finance but set against the prospect of steady low-risk returns from
natural monopoly. This provided investors with an attractive alternative to
government debt.
A crucial early development in Britain occurred in the textile industry:
the growth of the factory. As well as the massive impact on output, it is
significant for the development of management as an activity. Historically,
cloth had been produced domestically (for example, in the home),
usually by workers who had other concerns such as farming, using simple

9
equipment and raw materials provided by an entrepreneur – who was also
the purchaser of the finished product. This was a flexible and relatively
low-capital-cost operation, but it left the entrepreneur with little control
over production volumes. As the key historian of the Industrial Revolution
has noted:
…the domestic weaver or craftsman was a master of his time,
starting and stopping when he desired. And while the employer
could raise the piece rates with a view to encouraging output,
he usually found that this actually reduced output.
(Landes, 1969, p.59)
This backward-sloping labour supply curve arose because the workers
tended to have a subsistence income target, not a utility maximising one.
Cutting the rates did no good either − it led either to the worker quitting
or stealing some of the raw material in compensation (Salaman, 1981,
p.27). In short, incentives alone did not work. What the entrepreneur
needed was control of labour time and, to achieve that, work discipline
and the absence of alternative income sources. The answer: the factory,
in which workers were monitored (or managed). This was problematic
because it was not, generally, a process they welcomed (Thompson, 1968).
Now this process is highly significant. The modern economic theory of the
firm relies heavily on the ideas of monitoring, incentives and hierarchy.
Historians have debated the relative importance of these contractual
arguments for the growth of the firm versus technological ones; once the
factory existed, it became possible to apply steam power and technological
innovations in equipment to the raising of output, but the factory came
first.
Economic structure aside, there is no doubt that the scale of firms
increased. Prais (1976) quotes figures for both USA and the UK indicating
that in both by the late 1920s the 100 largest firms accounted for
approximately a quarter of all output. It was to rise to over a third by
1960. A vast amount of economic activity was moving from markets into
firms. With this, a vast amount of employment came to be located in large,
bureaucratic enterprises under formalised employment contracts. Let us
look at the story in slightly more detail, and chronologically.
2.4 Railways and the second Industrial Revolution
As Cassis (2007, p.175) puts it, ‘big business in the third quarter of the
nineteenth century primarily meant the railroad companies’. They became
exemplars in two ways. The first we have noted: they are almost the
prototypical joint stock enterprise in that they needed lots of investors. The
second concerns models of employment and management. They were the
first modern organisations to develop ‘extensive hierarchies of managerial
and white collar staff’ (Gospel, 2007, p.427). They engaged in systematic
recruitment, set up promotional hierarchies and pay scales. Assuming
lifetime or at least long-term employment, they introduced welfare
arrangements such as housing, sick care and pensions. In the UK at least,
they liked to recruit employees with a military or police background or
relatives of those already employed; this led to a readier acceptance of
the employment relationship as an authority relationship, necessary for a
dispersed workforce. There were no unions until after the First World War.
By the turn of the century, as Cassis notes, in a variety of sectors:
The large enterprise of the turn of the twentieth century…
appears as a centralised and vertically integrated firm, with its

10
own distribution and purchasing facilities, whose various
functions, including marketing, were entrusted to a hierarchy of
salaried managers, and which tended to cluster around sectors
where economies of scale and scope could be achieved through
mass production.
(2007, p.178)
This was more true of the USA than many parts of Europe.
The impact of the First World War was crucial. First, these mass-
production industries – food, chemicals, oil, engineering – became central
to the war effort, and expanded considerably. There was little product
market competition. After the war, there were further merger waves in
these sectors, particularly in Germany (Cassis, 2007, p.181). Big business
became bigger. Second, there was a massive change to the labour market:
labour markets were tight (because labour was scarce) and labour was
crucial to the fighting of industrialised war. In Europe, a significant
proportion of the male labour force was in the army, then dead. Unions
became strong and employers had to bargain. Global securities markets
collapsed. There was a mass of government debt to compete with equity
investment. Governments wanted to control the securities markets in
which this debt was traded and capital markets contracted. UK investors
sold massive amounts of overseas securities and the London stock market
became more localised. US investors had a very good war, and US markets
– particularly New York – grew massively. As Michie puts it:
…the global securities market was reduced to a series of
compartmentalized marketplaces only loosely linked to each
other rather than the fully integrated system that was in full
flow before 1914.
(2006, p.204)
After the War, in the 1920s and 1930s, government involvement in
business, particularly in European labour and capital markets, continued.
2.5 Market failure and management
Coase argues that firms exist because of market – or, more specifically,
price mechanism – failure in the presence of transaction costs.
[T]he fact that it costs something to enter into…transactions
means that firms will emerge to organize what would otherwise
be market transactions whenever their costs were less than
the costs of carrying out the transactions through the market.
(1988, p.7)
Certain types of transactions in markets entail considerable costs of price
discovery, negotiation and enforcement. For such transactions, Coase
argues, it may be more efficient for what he terms an ‘entrepreneur’ to use
‘authority’ to direct resources to their most efficient ends. The boundary of
the firm is set where the costs of organising a transaction within the firm
equal the costs of carrying it out through the market. Within this boundary,
the firm makes products or services; beyond it, it buys or sells them.
The revolutionary idea that Coase introduced in 1937 was the notion of
transaction costs. Much later, he argued that without transaction costs
firms would not exist, but nor would markets (1988, pp.6–8). Although
economists were primarily interested in markets, they focused primarily
on prices, and when they discussed market structure, they referred to
the number of firms and products, rather than the ‘social institutions that
facilitate exchange’ (1988, p.8) and thus defined transaction costs.

11
Coase has pointed the way to an explanation of why so much economic
activity took place outside markets, but it was many years before this
insight was pursued − we see how below. But what the market failure
approach did not do, was to offer a route to the study of the firm’s
internal operations. The stylised ‘entrepreneur’ allocated resources using
‘authority’ to maximise ‘efficiency’ and set the boundary of the firm where
market and hierarchy transaction costs equate. None of these concepts is
defined, and they really do not tell you much about what went on within
the firm. Coase is not really concerned with why some ‘entrepreneurs’
might be better than others. As a result, Coase made little impact – at the
time – on the study of management either. However, in the longer term,
the impact was substantial.
Several features of the Coase argument are replicated in much economic
theorising about organisations down to the present day. First, in the
pursuit of a theory of the firm, organisations are considered simple
alternatives to markets such as the pursuit of efficiency by other means.
There are two problems with this: first, firms may pursue multiple
objectives (of which efficiency is one), and since these objectives may be
in conflict, efficiency might not be the prime objective in the short term.
Moreover, there is no obvious reason why markets could not emerge from
organisational failure, rather than vice versa. In fact, much later, with the
growth of outsourcing, they did, and one needed to explain why a ‘make’
decision turned into a ‘buy’ decision, with the corollary that firm size
tended to shrink (Pfeffer, 1997).
Transaction cost arguments can provide a perfectly reasonable explanation
of this shrinkage, but Coase did not pursue it. Second, as Penrose (1959)
was to note many years later, markets do not make anything; they
exchange but do not produce – firms do both and are thus much more
than mere alternatives to markets. She makes the perceptive observation
that there is a difference between a theory of the firm and the economics
of the firm. Much later, Bromiley (2005, p.13) makes a parallel point
about the difference between explaining why firms exist versus explaining
what they do. For business strategy: ‘The existence of firms stands more
as a constraint on theorizing than an interesting problem; a theory that
predicts firms should not exist is clearly deficient.’
To use a metaphor: on the one hand, economists tended to see the world
as a sea of markets with the occasional island (the firm). Those who study
management tend to see the world as a desert of firms with the occasional
oasis.
The second feature which has endured in economics is the representation
of the firm in terms of one or more stylised actors; for Coase it is the
‘entrepreneur’, for later economists it is the ‘principal’ or ‘agent’. This
simplification enables formal modelling but it is not receptive to ideas
about organisational diversity or complexity; firms are timeless and
geographically unembedded. The third feature is that intra-organisation
relationships are treated in a very unproblematic way. Coase’s
‘entrepreneur’ exercised authority unproblematically, obeyed by those
she hired. For Jensen and Meckling, monitoring ensures compliance
and incentives provide motivation. Fourth, and related, rationality is
an assumption, not a variable. Actors within firms are built in the same
way as actors within markets, so that if one replicates the competitive
conditions of markets within firms, the same behaviours will emerge. By
extension, if an organisational feature is empirically common, logically it
must be efficient, since inefficient organisations will disappear over time.
Organisational diversity should disappear too.

12
This has had consequences for the relationship between economic theories
of the firm and empirical studies of what managers do, such as those
discussed below. Specifically, as Pfeffer (1997, p.46) notes, the economic
approach sees hierarchy design in terms of the prime need to control
managers with self-interested goals and employees who are effort-averse.
These assumptions about individuals within firms lead to the argument
that hierarchies have control and coordination costs, rather than focusing
on the positive impact managers might have on a firm’s performance.
In fact, as we shall see, were one to design an organisation according to
economic principles, it would probably be inoperable, primarily because
of the reaction of employees to such organisational controls. However,
before we turn to this, we need to look at the development of economic
ideas about hierarchy. Coase looked at market failure, but what about the
dynamics of hierarchy?
2.6 Transaction cost economics
Williamson’s early work concerned managerial decision-making; he found
that managerial discretion often undermined efficiency. Much later, he
would articulate the problems of the ‘propensity to manage’ in two forms.
It exists:
• instrumentally – managers pretend they can manage complexity,
when they cannot
• strategically – managers pursue their own sub-goals (Williamson,
1985).
However, rather than turning to markets as the answer, he focused on
the internal operations of the firm. The two aspects of ‘propensity’ rest on
two assumptions about individual behaviour which are core to the entire
project. Individuals are boundedly rational; they have limited capabilities
to deal with information complexity and information uncertainty.
Specifically, and crucially, they cannot write complete contracts. Second,
individuals are opportunistic, in that they pursue ‘self-interest seeking
with guile’ (1985, p.47); this is an extension of the conventional economic
assumption about the pursuit of self-interest which may roughly be
summarised as the idea that, since one cannot discover in advance who is
trustworthy, organisations need to be designed to cope with a pandemic of
dishonesty.
The third leg of this structure is the idea of asset specificity. The central
issue is the existence of human or physical assets which are locked into
a particular exchange relationship, for example, they have lower values
elsewhere. This might be ex ante; for example, you have to build a pipeline
to an oilfield and you are creating (in effect) bilateral monopoly. Or it
might be ex post; for example, you have worked in the same firm for many
years developing firm-specific skills. The three legs come together, as
Bromiley notes:
… efficient operation may require investments that have
little value outside that operation, but the parties cannot
trust one another, nor can they write the perfect contract…
bringing both parties to the transaction into the same company
(internalisation) may be more efficient than doing the
transaction in the market.
(2005, p.97)
As with Coase, transaction costs in markets and hierarchies are important
and Williamson borrows Arrow’s (1969) definition as follows:

13
• Ex ante costs: the costs of drafting, negotiating and safeguarding an
agreement
• Ex post costs: misalignment, haggling costs, the costs of running and
referring to governance structures, ‘bonding’ costs.
But contractual governance costs can be optimised in either markets or
hierarchies – ‘… transactions, which differ in their attributes, are aligned
with governance structures, which differ in their costs and competences’
(1985, p.27) so that transaction costs are minimised.
The influence of transaction costs economics has been substantial, perhaps
because of its scope, but also because of the nature of its assumptions.
Asset specificity alone does not give you the firm; opportunism is key.
Since opportunism is a very strong form of the self-interest assumption,
it has attracted substantial criticism. It is a very negative view of human
propensities (Ghoshal and Moran, 1996), it may well be ethnocentric and
it is not empirically grounded. However, it not only gives you a theory of
firm formation but also an approach to the optimisation of firm structure;
for example, Williamson explains the growth of the multi-divisional firm
in terms of efficiency – it economises on the transaction costs of capital
markets and minimises managerial activity detracting from shareholder
value (1985, p.288).
Activity 2.1
What assumptions about human behaviour does Williamson (1985) make? Try to make
a list.
Williamson also develops an approach to the employment contract which
is of generic interest to the relationships between owners, managers and
labour, which we discussed at the outset of this chapter. Employment
contracts are often characterised in economics as incomplete. They also
have asymmetric authority (the employer issues instruction), asymmetric
information (sometimes in favour of the employee), asset specificity (the
skills and equipment used are often not transferable) and they are often of
long duration. They are, empirically, the building blocks of hierarchy since
monitoring and incentives are central to them. Williamson’s approach can
be illustrated by reference to Figure 2.1.
Williamson (1985) discusses three contractual possibilities. Under spot
contracting the parties contract at T1 that, when event 1 occurs, the
exchange of money for effort (X1) will occur. If this occurs once, the
spot contract form is efficient. However, if the game is repeated, two
problems emerge. First, the transaction costs are high, both ex ante and ex
post. Second, opportunism – by both parties – is likely. Under contingent
claims contracting, the parties at T1 try to write a comprehensive contract
covering all events and their related effort bargains. This fails the bounded
rationality test in many circumstances, particularly where the number
of discrete events is high. The third option is adapted from Simon (who
was Williamson’s PhD supervisor). According to this approach the parties
agree to an authority relationship. The employee, in exchange for a single
comprehensive effort bargain, agrees to allow the employer the authority
to make state-of-the-world definitions across a range of events. The
problem here is how to define the acceptable range of events. However,
an authority relationship economises on transaction costs and does allow
some form of monitoring.

14
Spot contracts
T1..........E1..........X1
T2..........E2..........X2
T3..........E3..........X3
Contingent claims
E1..........X1
E2..........X2
E3..........X3
Authority relation
T1..........
T2.......... ..........X2
T3..........
Figure 2.1: Alternative contractual forms
What Williamson comes up with as the optimal form relies very heavily on
Doeringer and Piore’s (1971) idea of an ‘enterprise market’. He emphasises
several elements: internal promotion ladders to encourage on-the-job
training and cooperation, pay rates attached to jobs within these ladders
(rather than individual performance), ascending with position on the
hierarchy, moderate rather than intensive metering, and job security
bolstered by a grievance or arbitration procedure to resolve disputes. He
is, in effect, describing the institutional structure of managerial capitalism
– what Davis (2009, pp.195–200) has referred to as ‘corporate feudalism’
– in which long-term attachments between firms and employees, bolstered
by firm-specific benefits and privileges such as pensions, profit sharing and
long-term employment, characterised not only the fabric of managerial
work but, increasingly with the advent of labour unions and particularly in
the USA, that of all permanent employees. And a key part of the efficiency
gains that come from this considerable investment in hierarchy comes
from its impact on the behaviours of those in the hierarchy. His distinction
between ‘consummate’ and ‘perfunctory’ cooperation outlines but does not
perform a theory of value creation by managers.
Consummate cooperation is an affirmative job attitude –
to include the use of judgement, filling gaps, and taking
initiative… Perfunctory cooperation, by contrast, involves
job performance of a minimally acceptable sort … where…
incumbents… need merely to maintain a slight margin over the
best available inexperienced candidate.
Based on findings from different disciplines, understanding this difference
provided the motivation for the development of theories about both
management and labour performance.
Activity 2.2
What are the advantages to employers of long-term relationships with employees?
2.7 Overview of chapter
In this chapter, we have tried, first, to describe in brief the emergence of
the large firm and, second, to outline the first main attempt to develop a
theory of it. This theory has a number of features that are significant for
the chapters to follow.
1. It emerges essentially as a negative explanation about market failure:
firms are implicitly second-best structures that arise when markets
fail. Logically, one optimises the performance of a firm hierarchy by
making sure it runs as close to being a market as possible. Within

15
firms, managers potentially engage in problematic behaviours because
the structures bring out the worst in them – opportunism. Coase is the
precursor of a range of anti-managerial theories of organisation.
2. The theory is not empirically based. Not only is it surprising that
economics developed a theory of the firm long after firms came
to dominate industries (and then ignored it), it is surprising that
the theory was not informed by any extensive observation of
industry structure or firm behaviour. Empirical examination of the
internal operation of the firm has remained unfashionable within
economics and, as we shall see, it does not infect the modern field of
organisational economics very much either.
3. Because the transaction cost approach remained marginal to
economics for 30 years, and economics remained relatively
uninterested in the firm, a space was created into which business
disciplines such as marketing, organisational behaviour and strategy
moved. Academic economics becomes much more involved with the
study of managerial behaviour than with the growth of the economics
of strategy and organisation and, less directly, of financial economics
from the 1960s.
2.8 Reminder of learning outcomes
Having completed this chapter as well as the Essential reading and
• explain key elements in the history of the firm
• discuss the main theories of firm formation
• outline several key managerial problems in the firm.
2.9 Test your knowledge and understanding
What is transaction cost economics and why is it important for the theory
of the firm?

Notes
16

Chapter 3:Taylorism, motivation and performance
17
Chapter 3: Taylorism, motivation and
performance
• describe the main elements of Taylor’s approach
• discuss the strengths and limitations of scientific management
• explain the main elements of the human relations approach.
Willman, Theme 1.
Braverman, H. Labor and monopoly capital. (New York: Monthly Review Press,
1974) [ISBN 0853453403]; 1988 edition [ISBN 9780853459408].
Guillen, M.F. Models of management: work, authority and organisation in
a comparative perspective. (Chicago: Chicago University Press, 1994)
[ISBN 9780226310367].
McGregor, D. The human side of enterprise. (New York: McGraw-Hill, [1960]
2006) [ISBN 9780140091243] Chapter 1: Management and scientific
knowledge.
Taylor, F.W. The principles of scientific management. (New York, Harper, 1923)
[ISBN 9781599866796] Chapter 1.
3.1.4 Works cited
Abernathy, W.J. The productivity dilemma. (Baltimore: Johns Hopkins, 1978)
[ISBN 9780801820816].
Batt, R. and Moynihan, L. ‘The viability of alternative call centre production
models’, Human Resource Management Journal, 12(4), 2002, pp.14–34.
Burawoy, M. Manufacturing consent: changes in the labor process under
monopoly capitalism. (Chicago: University of Chicago Press, 1979)
[ISBN 9780226080383].
Granovetter, M. ‘Economic action and social structure: a theory of
embeddedness’, American Journal of Sociology 91 1985, pp.481–510.
Lewchuk, W. ‘Fordism and British motor car employees, 1896–1932’
in H.F. Gospel and C.R. Littler Managerial strategies and industrial
relations: an historical and comparative study. (Farnham: Ashgate, 1983)
[ISBN 9780435323653].
Marglin, S. ‘What do bosses do?’, Review of Radical Political Economics 6 1974,
pp.60–112.
Mayo, E. The human problems of an industrial civilization. (New York:
Macmillan, 1933).
Nelson, D. Frederick W. Taylor and the rise of scientific management. (Madison:
University of Wisconsin Press, 1980) [ISBN 9780299081607].
Nelson, D. A mental revolution: scientific management since Taylor. (Columbus,
OH: Ohio State University Press, 1992) [ISBN 9780814205679].
Norwich, J.J. A History of Venice. (London: Allen Lane, 1982)
[ISBN 0713915625].
Quattrone, P. ‘Accounting for God: accounting practices in the Society of Jesus’,
Accounting, Organisations and Society 29 2004, pp.647–83.

18
Rose, M. Industrial behaviour. (London: Penguin, 1988) [ISBN 0140091335].
Sabel, C.F. Work and politics: the division of labor in industry. (Cambridge:
Thompson, E.P. The making of the English working class. (London: Penguin,
1966) [ISBN 9780394703220].
Willman, P. Technological change, collective bargaining and industrial efficiency.
(Oxford: Oxford University Press, 1986) [ISBN 9780198272625].
Witzel, M. Builders and dreamers: the making and meaning of modern
management. (Harlow: Prentice Hall (2002) [ISBN 9780272654377].
Wren, D.A. The History of Management Thought. (New York, Wiley, 2005).
[ISBN 9780471669227].
3.2 Introduction
The 19th and early 20th centuries in Europe and USA were, arguably,
characterised by two features relevant to the design and conduct of
business. The first was a belief in technological progress (and its benefits).
The second was an inclination towards optimisation; put differently, if one
thought systematically and rationally about a business problem, one could
improve the chosen dependent variable – efficiency, productivity, profits,
etc. In the absence of a theory of the firm, many analysts and practitioners
felt the appliance of science to the factory could yield substantial benefits.
Many had an engineering background (Witzel, 2002) and, again arguably,
saw the optimisation problem as an engineering problem.
The problem to be optimised was how to run the most efficient business.
Intellectual furniture existed; there were not many examples of large-
scale manufacturing businesses but there was a history of large-scale
organisation in two fields: government (particularly military) and religion
(particularly international religious orders). In these organisations, many
‘managerial’ techniques had been developed. I offer two examples.
Jesuits knew about accounting. They had resources, international reach
and an objective: saving souls. But,
A strictly economic analysis of the nature and role of accounting
as an instrument for allocating, monitoring, and administering
resources within the hierarchical structure of the Society of
Jesus would leave undiscovered important aspects of the
practices deployed by the Order to manage, organise, and
account for its multifaceted activities.
(Quattrone, 2004, p.675)
How to optimise the allocation of resources to maximise the saving of
souls? The first thing one needs is a management accounting system to
tell you where the resources come from and go to. The second thing, more
controversial perhaps, is you have to put an economic value on a soul. At
the margin, one might have to choose which soul to save or whether the
expenditure was worth the return.
Venice knew about fighting wars at sea to generate and protect trade (they
are not the only historical example). In the Arsenale, they built assembly
lines.
[Venice] could standardise designs and build up stores of spare
parts, making it possible to complete even major refits in a
fraction of the time… the designs themselves, as well as the
techniques, could be revolutionized….One of the secrets of
Venice’s rise to power lay in the fact that she never saw the twin
necessities of defence and commerce as altogether separate…
the nobles were merchants and the merchants noble…
(Norwich, 1982, p.109)

19
How to maximise throughput and reduce production times;
standardisation of inputs, process and product is an important component.
Alignment of defence and commercial interests is another. You could use
the ships to fight and then carry the spoils home.
How are these examples relevant to the operation of the industrial firm
centuries later? First, they indicate that techniques for resource allocation
and mass production had a long history in ostensibly non-commercial
operations which could be adapted; there was something to work on
for engineers to optimise. Second, they hint at the source of the agency
problem in business. Military operations (which are a matter of life
and death) and religious organisations (which are a matter of afterlife
and eternal death) can generally exert more forces for cooperation or
compliance on organisational participants than organisations that rely
primarily on shared financial interests. Borrowing the techniques from
such organisations did not borrow the underlying cooperation.
In much of the West, for the majority of the early period of
industrialisation, it was not entirely clear why a pre-industrial workforce
would wish to become an industrial one (Marglin, 1974; Thompson,
1968). If one invested in a factory in, for example, the cotton industry
in England (which was important for the first Industrial Revolution),
the capital investment required in steam production and productive
equipment required high rates of utilisation which in turn required long
hours of work. Control of absenteeism, turnover and simple inactivity was
required to generate a rate of return. What incentives could be used to
exact this? Money is one obvious answer, but we saw also the problems
with simple incentives in the last chapter. Moreover, what would one buy
with it? Penalties are another; throughout the 19th century in England,
employment in factories was governed by the ‘master and servant’ Acts;
the presumption of obedience was central. A third was the removal of
opportunities. Prior to factories, farmers and their families used to spin
cotton as an activity supplemental to their central activities. With the
advent of expensive machinery, such an approach became hazardous
to profit, and the need for a workforce with no other means of support
became paramount.
Many management ‘theorists’ emerged in the late 19th and early 20th
centuries, convinced that applying scientific principles to the management
of firms would result in improvements in efficiency and productivity and,
for the more messianic, a better world. The term ‘scientific management’
has often been applied to the ideas they promoted. We will look at just
the most influential, F.W. Taylor, however, several characteristics of the
set are relevant. First, they were obsessed with efficiency as an outcome
variable; many of their works display a strong tendency to sample on this
dependent variable, often with erroneous results. Second, they believed
in general rather than specific solutions; their recipes were in principle
universally applicable and promoted one best way of doing things. Third,
they inclined, like Emerson and Fayol, to sets of points or principles which
summarised their approach; 12 principles of efficiency for Emerson, 14
points of administration for Fayol. Fourth, since they were often engineers,
they saw agency problems in engineering terms. Employees were
important appendages to machines ‘and in the interests of plant efficiency
should be treated at least as well as we treat machines’ (Emerson, cited
in Witzel, 2002, p.227). Some were even military engineers who saw the
exercise of authority as unproblematic.
An enormous amount has been written about Taylor (Braverman, 1974).
He tends to be better thought of by those in operations management and

20
research who are interested in the optimisation of processes than by those
in organisational behaviour who are interested in the human response
to this. Frederick Taylor argued that ‘scientific management’ consisted
in devising the one best way to complete a task and then ensuring the
workmen closely followed the rules, using supervision and monetary
incentives. Five principles were central.
• The separation of conception from execution: managers analysed and
designed work tasks, employees performed them.
• Simplification of tasks: each task was broken down into simple
components which were then aggregated to exclude unnecessary
efforts.
• Close supervision: employees were closely monitored to ensure
adherence to best practice.
• Strict obedience to ‘one best way’: employee innovations in work
design were excluded.
• Monetary performance incentives were applied to output generated in
this way.
After initial successes, Taylorism was adopted by large firms such as
DuPont and Ford. It was seen at the time as industrial science not capitalist
ideology – Lenin was a fan. As we shall see, elements of it were adapted
much later. It provided one basis for the modernisation of Japanese
industry in the post-Second World War period. Its utilisation in service
businesses grew as scale economies were pursued. ‘The factory of the past
becomes the office of the future’ (Batt and Moynihan, 2002). However, it
generated some of the characteristic problems of later versions of agency
theory. The model ‘first-class’ workman in Taylor is a passive and obedient
agent, indeed selected on those characteristics.
Let’s put the above list together, again in a negative way.
• Separation of conception from execution – the operator has no
incentive to learn or share learning. If the operator does learn a better
way, he is likely to appropriate the benefits.
• Simplification of tasks – skills are not worth developing, either
for the firm or the employee. Indeed ‘de-skilling’ and thus loss of
market power by employees is seen as one major consequence of the
application of Taylorism (Braverman, 1974).
• Close supervision – many supervisors are needed and overhead rises.
Taylorist firms develop high supervisory ratios, and efficiency losses.
• Strict obedience to ‘one best way’ – attracts the intrinsically obedient
who are unlikely to innovate.
• Monetary performance incentives – given that people respond to
symbolic rewards – this is expensive and likely to generate a simply
calculative approach by the employee.
In fact, Taylorism depends on what in a different context Granovetter
(1985) has referred to as both an oversocialised and undersocialised idea
about the employee: oversocialised into obedience and undersocialised
in being entirely motivated by money, not intrinsic rewards. Moreover,
Taylor’s optimal employee is individually selected not collectively
organised; in early 19th-century USA, this emerged as a problem.
Activity 3.1
Consider an organisation you know − school, shop, office.What would be the advantages
and disadvantages of applying scientific management to that organisation?

21
Let’s look at the model of organisation and of management. Organisations
are seen as machines. Some of the machines are people but they can be
managed the same way: managers think, workers do. Standardisation
of (labour) input, work process and product output are the sources of
efficiency; this is a mass-production model. The market does not send in
shocks that disturb the organisation of work on a regular basis. Employee
recalcitrance is endemic and monitoring is permanent. Task- or peer-based
intrinsic rewards do not operate and the employee is homo oeconomicus.
How well has Taylor understood the employee as economic man?
We would argue that in at least two respects the Taylor approach
anticipates later developments by academic economists, albeit not
formally.
• In the emphasis on the importance of selection and fit, there is
understanding of both moral hazard and adverse selection.
• In the rigid adherence to the separation of conception from execution,
there is a grasp of the problems of information asymmetry.
3.3 Scientific management: the apogee
Scientific management in general and Taylor’s version in particular left a
substantial legacy. The engineering efficiency approach to the design of
operations generated huge returns to scale, and many large businesses
in chemicals, engineering and car manufacture adopted it (Nelson,
1992). Much of the thinking was to become incorporated in the academic
disciplines of operations research and management, which in turn found
a central place in the MBA curriculum. For many, the ultimate expression
of the engineering approach to production management came in the car
industry, and in particular the operations of Ford, the most successful of
the early car manufacturers.1
Ford dominated the early history of the car industry, both in success and
failure. The Model T introduced in the 1920s was based on a strategy of
low price and simple design; this generated huge growth in car ownership
and thus market size. The production approach underpinning this was
standardised design, assembly line technology and mass production. This
had a number of implications. For Ford, the most serious was inflexibility;
his early factories could only produce Model T cars, and retooling for
product innovation required long-term plant closure that led to permanent
loss of market leadership to General Motors (Lewchuk, 1983).
In assembly line car production, capacity utilisation is vital. Mass
production degenerates into batch production whenever the line is stopped
or product rectification is required; fixed capital costs are high, and the
gap between capacity and output needs to be small. This is exacerbated by
vertical integration; car assembly – the final operation before distribution
and sale – has lower minimum efficient scale than upstream operations
such as engine manufacture and body production, so interruptions to
assembly within an integrated car manufacturing operation generate costs
throughout the firm. Assembly is also the most labour-intensive phase of
production.
1
This section relies on
Abernathy (1978) and
Willman (1986).

22
PRESS SHOP BODY SHOP PAINT SHOP
Stamping of
body panels
Steel: sheet
strip and coil
Panels
Sub-
assemblies
Body
assemby
Body in
white
Clean, prime,
paint body
Painted body
ASSEMBLY PLANT
Trim lines
Final
assemby
Test and
rectification
Finished car
shipped to
distributors/
dealers
Thousands of parts
and trim items
Component
plants Engine dress
and rear end
assembly
RAW-
MATERIAL
SUPPLIERS
Steel: rod and
bar stock
Forging of high-
strength parts
FORGE
Casting of engine
blocks, crankshafts
etc.
FOUNDRY
Machining
Machining
ENGINE PLANT
Engine
assembly
and test
TRANSMISSION PLANT
Transmission
assembly
and test
Engine
Transmission
Figure 3.1: Cost components of car assembly
Figure 3.1 identifies the cost components of car assembly. There are three
sets. First, capital equipment in the form of plant layout; this defines
capacity and is fixed. The next two concern labour. The first is the hourly
cost of labour. If the system is optimised at 100 per cent operation, these
are the only costs. The third component represents lost capacity; the source
of most lost capacity is labour behaviour, and control of this is at the centre
of the derivative of Taylorism that some commentators call ‘Fordism’. The
key dependent variable is ‘man hours per car’, for example, the labour
input to each unit produced. Absenteeism, errors in work, stoppages due to
disputes and the need for direct supervision inflate this denominator.
The key elements of the labour strategy that supports optimisation were as
follows.
• The simplification of tasks and high assembly line speeds; automation
of simple tasks where possible.
• Use of high levels of hourly pay and the avoidance of bonuses. Ford
introduced the ‘$5 day’2
to attract and retain the labour required, and
to reduce absenteeism.
• Close supervision of employees and strict discipline.
• Avoidance of labour unions.
In order to do this, Ford favoured company towns and company housing.
Most significantly the firm invested in a ‘personnel department’ that
not only provided welfare but also acted as a labour police force,
monitoring absence, sickness, agitation and dissent. Optimising workforce
performance was the key to optimising capacity utilisation. The main
Taylorist absentees from this labour-management formula were incentives
and heavy supervision; assembly line speeds substituted for both
(Guillen,1994, p.56).
Many of these considerations still apply to the modern car industry.
By extension, they apply to many capital-intensive mass-production
operations. Labour costs may be a small proportion of total costs, but
labour control becomes vital. As Braverman has put it:
2
This was a lot of money
at the time.

23
Taylorism dominates the world of production; the practitioners
of ‘human relations’ and ‘industrial psychology’ are the
maintenance crew for the human machinery.
(1974, p.86)
How did psychology intervene, and what is ‘human relations’ in this
context?
3.4 Engineering and psychology
There were parallel but discrete origins in the USA and UK. In the USA,
Munsterberg at Harvard – an admirer of Taylor – became concerned with
fatigue, monotony and learning in work; he advocated selection testing
and motivational tools. In the UK, the influence of wartime research on
soldiers was deployed in the 1920s by Myers, among others, to study stress
and fatigue and to develop recommendations on the optimal working
day and rest periods and the avoidance of accidents and absenteeism
(Rose,1988). The unit of analysis tended to be the individual worker (and
by extension individual differences), but the concern was less directly with
individual well-being and more with those variables also of concern to
scientific management. As Wren puts it:
While the engineer studied mechanical efficiency, the industrial
psychologist studied human efficiency with the same goal in
mind of improved overall greater productivity. Acceptance
by industry of the heretofore ivory tower psychologist was
facilitated by the psychologist’s interest in efficiency.
(2005, p.193)
A paradox of early theorising about employee behaviour was that
both scientific management and the early psychologists focused on the
individual as the unit of analysis but the employee response to both
frequently involved collective action, which in turn generated the high
levels of labour conflict that were of so much concern. An alternate
approach relied on late 19th-century sociology and focused on the group.
Durkheim focused on the bonds that held societies together to generate
solidarity. Traditional societies were bound together by kinship, religion
and similarity; this generated ‘mechanical solidarity’. The division of
labour, the growth in differentiation of status and the scale of modern
societies broke down these bonds and generated anomie; this was an
individual state of confusion, normlessness and anxiety, but it was
generated by the absence of any groups or institutions that could provide
a set of norms and values appropriate to a highly differentiated society –
‘organic solidarity’. Durkheim’s work contains far more analysis of societies
with mechanical solidarity than those with organic and he is a little short
on detail about how it might be achieved. The enduring legacy for the
management field was his concept of the individual as plastic, shaped and
shapeable by membership of norm-generating groups.
To get from this to a set of management techniques one needed something
approaching an optimisation model – and it came from economics. Pareto,
a 19th-century polymath who was an engineer, economist and sociologist,
referred to the idea of a ‘social system’ – characterised by interdependent
and varied components with self-equilibrating tendencies. This went into
Harvard University as a broad idea and came out as a major influence on
academic sociologists such as Parsons and Homans on the one hand and,
on the other, as a central plank of what became the ‘human relations’
school – the idea of the factory as a social system that could achieve

24
equilibrium. In order to explore this approach and its effect on modern
management theory, let us look at its most famous piece of research – the
Hawthorne studies.
The Hawthorne studies took place in the USA in the eponymous plant
of Western Electric from 1924–1933.3
It was a massive factory; by 1929,
40,000 men and women worked there. Western Electric was one of the
forerunners in applying scientific management to its production units
and it was regarded as a well-run plant. Numerous researchers using a
variety of methods performed a series of behavioural experiments and
deployed interviewing and observation techniques in ways that would get
modern researchers fired and, given that the experiments involved some
behavioural manipulations and physical deprivations, maybe sued (Wren,
pp.370–73). In fact, the most widely quoted finding is simply a method
flaw. Over time, researchers realised that every time they paid attention
to a group of workers (subjected them to a ‘treatment’) output rose
temporarily, then fell back – the ‘Hawthorne effect’.
The studies began with a concern for physical environment. The
illumination tests, 1924–1927, subjected groups to lighting variations
and, broadly, found no correlations between lighting and productivity.
Subsequently, the ‘relay’ tests, 1927–29, involved experimental alteration
of bonus arrangements, rest periods and hours of work, with mixed
results. A third set of studies, in the ‘Bank Wiring Room’, probably had the
greatest impact. Researchers discovered output restriction under incentive
schemes that was enforced by informal groups. Workers felt that if they
produced too much output, management would cut the rates, and if too
little, they would be disciplined. Informal work groups emerged enforcing
output norms lower than those management wanted, using emotional and
physical sanctions. Further studies analysed informal group structure in
depth, finding that supervisory behaviour with respect to informal groups
was important. Managers who listened and communicated well were likely
to be more integrated into work groups.
The results had potentially radical implications. Workers would act against
self-interest by obeying group output norms. Managers who integrated
with informal groups, using what would later be called a management
‘style’, gained much better understanding of group structure and how
to manipulate it. Such groups could be used to improve output. In these
studies we see the seeds of the organisational behaviour discipline –
in its concern with intrinsic (non-economic) motivators, teams and
team building and leadership. We can also see a logic which leads to
the development of the modern human resource function; individual
and collective affect (emotional states) may have an impact on firm
performance, and it is thus worth investing to control these variables.
More immediately, it allowed one of the key researchers, Elton Mayo, to
identify worker discontent as anomie remediable by intervention designed
to restore Pareto equilibrium to the social system of the factory. The
intervention points were selection of workers, allocation and organisation
of tasks, leadership style and the construction of teams (Guillen,1994). To
quote Mayo:
The hallmark of human-relation theories is the primacy given
to organizations as human cooperative systems rather than
mechanical contraptions…
Any company controlling many thousands of workers…tends…
to lack any satisfactory criterion of the actual value of its
methods of dealing with people.
(Mayo, 1933)
3
This section relies on
Rose (1988).

25
Since cooperation was the objective, unions were peripheral to the
analysis.
Hawthorne in particular and the human relations school in general
have been subject to a number of criticisms. However, the impact of
human relations thought on subsequent academic research agendas is
considerable, and the notion that the ‘mechanical’ and the ‘social’ systems
of industrial enterprises must be jointly maximised was exported from the
USA, most particularly in the work of the Tavistock Institute.
In an influential study, Guillen has analysed the theoretical development
of both scientific management and human relations thought, and their
impact on business practice in four Western countries. He argues that:
The development of engineering as a profession was the direct
cause of scientific management, much as the development of
social-psychological science accounted for the appearance of the
human relations paradigm.
(Guillen, 1994, p.26)
Scientific management adoption always precedes human relations
adoption, and indeed in Germany he finds, for various reasons, human
relations thinking has little effect on practice. The more consistent
impact of scientific management on production is associated with the
simultaneous development of cost accounting, production and inventory
controls and incentive schemes (also developed by engineers) (1994,
p.41).
If, as in the USA, human relations thinking emerges as a solution to
problems of labour unrest generated by the application of scientific
management, its ideological component becomes important. Several
eminent sociologists in the 1950s, such as Daniel Bell, C. Wright-Mills and
W.H. Whyte, saw human relations as a manipulative technique promoting
solely managerial ends; later Marxist sociologists such as Braverman
(quoted above) saw it as ‘manufacturing consent’ (see also Burowoy, 1979,
and Sabel,1982). In Britain, however, it gave rise to a set of concerns
about humanising the workplace through the reorganisation of work.
Activity 3.2
One key question emerging here is the relative primacy of engineering and social
considerations. Does one, as Braverman implies above, (a) optimise on process efficiency
and productivity and mould social concerns around that (as the human relations approach
implies), or (b) is it worthwhile to choose a sub-optimal production technique because
it has compensatory effects on the workplace as social system which, in turn, positively
affects some performance measure?
1. Early theorists were concerned to optimise production in large firms
using both existing organisational tools and a systematic ‘engineering’
approach.
2. This became systematised in the influential work of Taylor whose
techniques were widely adopted and developed.
3. However, widespread concern about the approach to employees
led to the application of social psychology to understanding worker
behaviour, also in the interests of increasing performance.
4. This in turn led to the emergence of the ‘human relations’ approach.

26
• describe the main elements of Taylor’s approach
• discuss the strengths and limitations of scientific management
• explain the main elements of the human relations approach.
What was scientific management? Is it still influential in business today?

Chapter 4:The rise and decline of labour
27
Chapter 4: The rise and decline of labour
• outline the key features of the history of labour unions
• describe the potential benefits of unions to firms and employees
• discuss the reasons for union decline in modern industrial societies.
Freeman, R. and Medoff, J. What do unions do? (New York: Basic Books, 1984)
[ISBN 9780465091324] Chapter 11.
Willman, Chapter 3, Theme 2.
Gospel, H. ‘The management of labor and human resources’ in Jones, G. and
J. Zeitlin, J. (eds) The Oxford handbook of business history. (Oxford: Oxford
University Press, 2007) [ISBN 9780199573950], pp.420–47.
Pencavel, J. ‘The demand for union services: an exercise’, Industrial and Labor
Relations Review 24(2) 1971, pp.180–90.
4.1.4 Works cited
Berg, M. The machinery question and the making of political economy.
(Cambridge: Cambridge University Press, 1980) [ISBN 9780521227827].
Blanchflower, D. and A. Bryson ‘Changes over time in union relative wage
effects in the UK and the US revisited’, Chapter 7 in J.T. Addison and
C. Schnabel (eds) International handbook of trade unions. (Cheltenham
England and Northampton Mass., USA: Edward Elgar, 2003)
[ISBN 9781840649796].
Blanchflower, D. and A. Bryson ‘What effect do unions have on wages now?’,
Journal of Labor Research 25(3) 2004, pp.383–414.
Braverman, H. Labor and monopoly capital (New York: Monthly Review Press,
1974) [ISBN 9780853453406].
Crouch, C. Trade unions: the logic of collective action. (London: Fontana, 1982)
[ISBN 978006358732].
Davis, G. Managed by the markets. (Oxford: Oxford University Press, 2009)
[ISBN 9780199216611].
Freeman, R. and J. Rogers What workers want. (Ithaca: ILR Press, 1999)
[ISBN 9780801485633].
Gomez, R., A. Bryson and P. Willman ‘Voice transformation: the shift from
union to non-union voice in Britain’ in A. Wilkinson et al. (eds) The Oxford
handbook of participation in organisations. (Oxford: Oxford University Press,
2010) [ISBN 9780199207268].
Hobsbawm, E. The age of extremes: the short twentieth century, 1914–1991.
(London: Michael Joseph, 1994) [ISBN 0718133072]. Vintage (1996)
[9780679730057].
Marglin, S. ‘What do bosses do?’, Review of Radical Political Economics 6 1974,
pp.60–112.
Tuchman, B. The proud tower. (London: Macmillan, 1966)
[ISBN 9781299237247].

28
Willman, P. Technological change, collective bargaining and industrial efficiency.
(Oxford: Oxford University Press, 1986) [ISBN 9780198272625].
Willman, P., T.J. Morris and B. Aston Union business: trade union organisation
and financial reform in the Thatcher years. (Cambridge: Cambridge
4.2 Introduction
Although circumstances in the 19th century differed between Western
countries, particularly between nation-states in Europe and the immigrant
society of the USA, it is fair to say that industrialisation in both required
the creation of an industrial labour force. The rhythms, seasonality and
control structures of a pre-industrial and agrarian society were very
different from those needed by factory systems in the 19th century. This
was the transition that obsessed both Marx and Durkheim. Although
their analyses were very different, they were both concerned with the
disappearance of one labour pattern and its replacement by another. In
practice, it was a process that was both political and economic, full of
conflict, and lasting in its impact on both industrial practice and academic
theory.
This chapter is not a full history of this process. It is structured around
several propositions. First, industrialisation in general and the factory
system in particular required a labour force substantially different both
in its social structure and its labour practices from what preceded it.
Second, this was neither a comfortable nor welcome process for many
members of that labour force, and their resistance to it took the form both
of unionisation and political action. Third, the performance attributes of
that labour force were sufficiently central to the success of specific firms
that strategies for the management of workforces needed to move beyond
compulsion to cooperation: capital-intensive operations required both
skills and continuity, and both gave employees bargaining power. Fourth,
the generation of compliance necessitated a specific set of managerial
activities which began as labour welfare and continues as human resource
management.
Eric Hobsbawm (1994), a Marxist historian, coined the term ‘the short
twentieth century’ to refer to the period between 1914 and 1991. It covers
the period from the start of the First World War to the collapse of the
former USSR. It was in his interpretation one long set of wars, conducted
by different means but which, particularly for Europe, resulted in major
changes for labour and labour markets. Millions of employees put on
uniforms and were killed. Immigration to the USA aside, international
labour mobility shrank massively. But production and labour compliance
became central to the fighting of wars that were won, increasingly, by the
industrial production of food, energy and fighting machinery. In the latter
part of the period, the central conflict was between a capitalist system
and an ostensibly socialist, worker-owned, one. The paradox for both
was that labour had to be controlled, but it also had to be bought. In this
climate, we see the elaboration of the institutional machineries of labour
performance and cooperation. In order to set the stage for this, let us turn
to 19th century background.

29
4.3 Farmers and workers
Textiles in England were crucial to the first Industrial Revolution (Gospel,
2007). Factory owners installed machinery, attracted labour and exerted
control over it (Marglin, 1974). Advocates and critics alike were under no
illusions about the dominant forms of managerial control. Contemporary
commentators, such as Ure, spoke of the ‘bloodless strife’ of trade and
used military analogies to describe hierarchy and authority (Berg, 1980,
p.201). Critics such as Marx spoke of male employees as ‘sergeants’ and
women and children as ‘soldiers of the line’ (Braverman, 1974, p.64).
Machinery fragmented work, controlled workers and shifted power to
owners; machinery was broken in riots, rioters were imprisoned and
transported. Unionisation emerged, primarily among the ‘sergeants’ who
possessed scarce skills and bargaining power, not among the women and
child soldiers. Textile unions consisting of male workers became among
the largest in Britain. Similar patterns of labour force development, but
not necessarily unionisation, developed in the USA and Japan (Gospel,
2007, p.425).
Railway companies came to dominate both the industrial landscape and
the capital markets but, although military analogies were explicitly used in
employment relations, the direct control approach to labour management
was not. Railway operation does not generate huge concentrations of
employment: employment is dispersed across the network and direct
supervision is very expensive, but the potential for the disruption of service
by a discontented workforce is enormous. The solution was largely the
same in both the UK and USA: railways developed elaborate internal
labour market structures with equally elaborate employment-dependent
benefit systems to retain and pacify labour, without unions, until after the
First World War.
Subsequently, as we have seen, large firms came to dominate Western
economies. There are a number of ways to measure firm size; we could
use volume or value of output, financial resources, market value or
market share. For the present purposes, employment is the appropriate
measure and Gospel has summarised the broad historical sweep of labour
concentration. Referring to the UK, the USA, Italy and Germany, but also
to Japan, he observes:
With slight differences between countries, the typical large employer in
the early to mid-19th century was a textile company; by the mid- to late
19th century, the biggest single group of major firms in most economies
were railway companies; by the mid-20th century, the main groupings
were manufacturers (steel, chemicals, automobiles, electrical) and by
the end of the 20th century, the biggest single group of large firms was
to be found in retailing and financial services.
(Gospel, 2007, p.424)
Throughout the ‘short’ 20th century in Western economies, which
also roughly coincides with Davis’s period of ‘corporate feudalism’
characterised by managerial autonomy, these large firms had to come to
terms with the ‘labour problem’. As we will see below, organisational size
is a potent variable that explains many features of organisational structure
and performance, and labour conflict is no exception. Unionisation
spread in Western countries throughout the large manufacturing and
service companies listed above. It also spread throughout government
employment. The trends for the USA and the UK are shown in Figure 4.1.

30
Figure 4.1: Long-term trends in unionisation in the USA and UK
Source: Willman (2014).
4.4 Band of brothers
In both countries, the ‘short twentieth century’ was a better period for
union membership than that which went before or since. The initial
turning point was the First World War, but the Great Depression was a
bad hiccup. Recovery from the Depression dip roughly coincided with
the Second World War. As we have noted above, tight labour market and
product market conditions were very important, but government action
to incorporate an organised labour movement into the war effort was also
key. This was particularly important in Europe; for example, in 1914 it was
by no means clear to contemporary politicians that trade unions loosely
coordinated by the international socialist movement would support a call
to arms that would have union members from different countries fighting
each other (Tuchman, 1966). High levels of unionisation were sustained
in many Western economies throughout the post-war period of corporate
feudalism, but as Figure 4.1 (above) shows, decline started to set in from
the late 1950s in the USA and the 1970s in the UK. There are very few
Western countries (the exceptions are mostly countries in Scandinavia)
that have not seen sustained decline in union membership, particularly in
the private sector, since the mid-1970s.
Three questions concern us here. First, why did unionisation become
widespread in the short 20th century? We deconstruct this into two
subsidiary questions: why do workers join, and why do managers in firms
choose to deal with them? Second, what changed to cause union decline in
the late short 20th century? Third, what is the impact of this phenomenon
on theorising about management? These questions will be examined in the
remainder of this chapter.
First, union membership: unions provide their members with three kinds
of service (Pencavel, 1971). They represent them collectively in wage
and benefit bargaining; individually in collectively agreed grievance
and disciplinary procedures; and they offer personal insurance against
misadventure such as unemployment or ill health. There is widespread
evidence from Western countries in the modern era that unions can
generate benefits for workers who are members. These benefits may be
monetary: there is a union wage differential (for example, a premium
United
Kingom
United
States
TradeUnionDensity%
0
10
20
30
40
50
60
1900
1905
1910
1915
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1925
1930
1935
1940
Year
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
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2005

31
union members are paid as compared with similar non-union workers)
in many Western countries, particularly in the USA for much of the 20th
century, although this declined as union density declined in the latter half
of this century (Blanchflower and Bryson, 2004). Table 4.1 indicates that
the amounts in some countries may be substantial; there are also sectoral
and skill-based differences within countries.
There is, equally, substantial evidence that employees want to be
represented in their dealings with employers (Freeman and Rogers, 1999).
We saw in Chapter 2 that employment contracts are incomplete; they
contain many ‘silences’ that must be filled by discussion or negotiation and
individuals often want to be represented in this process. There is some
evidence from the UK that this is increasing in importance compared to
collective action (see Figures 4.2 and 4.3)
Country Years Union % increase
Australia 1994, 8 & 9 12
Austria 1994, 5,8 and 9 15
Brazil 1999 34
Canada 1997-9 8
Chile 1998, 9 16
Cyprus 1996-8 14
Denmark 1997-8 16
France 1996-8 3(ns)
Germany 1994-9 4(ns)
Italy 1994, & 8 0
Japan 1994-6, 8, 9 26
Netherlands 1994 & 5 0
New Zealand 1994-9 10
Norway 1994-9 7
Portugal 1998-9 18
Spain 1995, 7-9 7
Sweden 1994-9 0
UK 1993-2002 10
USA 1973-2002 17
Table 4.1: Union wage differentials in selected countries
Source: Compiled from data in Blanchflower and Bryson, 2003 and 2004.
We read this modern evidence back into the argument for the early 20th
century growth of unions at our peril and with some conditions. Strike
activity in the early 20th century was – to generalise – much higher than
in the last quarter of the century in most countries, but it is probably the
case that most employees who joined unions did so for instrumental (i.e.
such as benefit-related) reasons, so it was in the unions’ interest to confine
those benefits to members and prevent spillover to non-union members.
This is relevant to the third category of services – individual insurance.
Early unions operated in the absence of a welfare state and thus were
often as much benefit societies as bargaining agents as they had the funds
to provide sickness benefit, unemployment benefit and funeral benefits
(Willman et al., 1993). Over time, and with the growth of corporate
feudalism and government-provided welfare, these benefits dwindled. In
late 20th century Western Europe, employees were likely to rely on the
state for many benefits, and in the USA it was the firm that employees
relied on. As Davis (2009, p.59) notes, American multinational firms

32
took on some of the welfare functions performed elsewhere by European
welfare states. Embedded here is the hint that the firm can substitute for
the union in providing certain types of employee benefit (see the next
chapter).
Either way, since the wage differentials of union membership were often
generalised to all employees, unions in the late 20th century had a harder
and harder time justifying the instrumental rewards of union membership.
There is very good social-psychological evidence to show that some people
join unions for ideological, or at least non-monetary, reasons, but none
to show that this can be the basis of mass membership. As Crouch (1982,
p.55) noted, unions had to develop a range of services that were unrelated
to their central public purpose but met some needs of potential members
and which were available only to members.
Figure 4.2: Stoppages 1960–2006
Source: UK Data ‘Stoppage days’.
Activity 4.1
Think about the reasons why employees join unions. Do they explain why union membership in
the UK and USA is in long-term decline? (See Figure 4.1.)
Figure 4.3: Employment tribunal claims registered 1972–2006
Source: Advisory Conciliation and Arbitration Service.
So, employees could see some benefits in union membership, but why
would firms agree to deal with unions? There are at least three ingredients
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
1500
2000
2500
3000
3500
4000
4500
1000
500
0
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1986
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1990
1992
1994
1996
1998
2000
2002
2004
1985
1987
1989
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1995
1997
1999
2001
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2006
0
40,000
60,000
80,000
100,000
120,000
140,000
20,000

33
to the answer. First, because the economic benefits often outweighed the
costs − this is essentially a bargaining power argument. In a railroad or
steel mill, for example, labour costs tend to be a small proportion of total
costs, but withdrawal of labour can lead to enormous costs, therefore
the union wage differential might seem cheap at the price. Second (and
implied by the first) there are economic rents that managers, autonomous
of owners, can share to make their job easier (the agency argument from
Chapter 2 may be relevant here). But, third, what if unions could be
managed to provide benefits to the firm?
The argument for firms dealing with unions is put forward by Freeman
and Medoff (1984). Their dependent variable is labour productivity; the
outcome is indeterminate, dependent on the three effects; the reasoning
is purely economic; and the identification of ‘voice’ solely with labour
unions is an assumption. But the argument is that, since higher-priced
labour (monopoly wage gains) should either get you better labour or make
it easier to automate, and ‘voice’ should both lower exit and improve the
quality of management, these two effects could generate net benefits if
management controls are sufficiently strong to prevent the establishment
of unproductive work rules (known as featherbedding).
The data they use to justify this is from the USA. There are some data from
elsewhere that point the same way. To repeat, this is an argument about
why firms need voice, not why they need unions. But it also indicates
why unionisation might have become so prevalent in the Western private
sectors where oligopolistic competition existed, since it defines the set
in which the costs of unions to employers might be less than the benefits
(Gomez et al., 2010). It may also point the way to the answer to the third
question about the decline of unions.
However, first we need to identify some properties of the set of
circumstances in which union effects on productivity are negative. Under
what circumstances is the positive outcome described by Freeman and
Medoff (1984) unlikely, and the costs of union activity likely to outweigh
the benefits to employers? A note of caution: such circumstances used to
and do exist. Here we identify four; they are not mutually exclusive.
• Perishable products and spot contracting. Perishable products
are those that need to be produced, sold or moved before their market
value disappears. When their production, sale or movement depends
on labour, substantial bargaining power devolves on collectively
organised labour. In many such markets, there is volume volatility
or uncertainty. Let us offer two historical examples (Willman, 1986).
Newspapers used to be produced by typesetting methods that required
substantial, skilled labour. But nobody knows how much news
there will be tomorrow and nobody needs yesterday’s paper. In this
situation, labour power is substantial and labour demand is variable.
Dock (longshore) work is similar. Ships arrive at uncertain times and,
because they are charged to be in dock and because many products
need to be unloaded fast, similar uncertainties existed. The central
question is: who bears the volatility risk? In both industries, in many
countries, the employer solution was to generate a hiring hall: each
day, employers would hire from a larger pool the labour they needed,
so the potential employee bore the risk. This is, in Williamson’s terms
(see Chapter 2), a spot contract in the labour market. The union
response is uniform, which is to shift the volatility risk, shrink the
available labour pool by limiting it to union membership and exact
compensatory payments equivalent to wages for those not hired, so
the employer has limited hiring options and no incentive not to do so.

34
In the two industries mentioned, it meant that union members became
among the highest-paid manual workers in their respective economies.
In the short term, the management control problem was intractable. In
the longer term, the automation of both industries swept the problem
away.
• Natural monopoly. Whether in the public or private sector, unions
maintain substantial powers in situations where monopoly enables
them to inflict considerable damage on the consumer. Examples would
be power supply and transport in the private sector or education and
health, which is most often to be found in the public sector. Bargaining
power for unions is enhanced where skills levels are high, and thus the
substitution of current employees is difficult in the event of conflict.
This natural monopoly may be local; by this we mean that it may
be internal to the firm in the form of a production bottleneck. For
example, in a large-scale retailing operation, unions find it difficult to
organise a high turnover and dispersed group of employees in stores,
but much easier to organise drivers who distribute saleable and perhaps
perishable products, who are concentrated and smaller in number.
• Occupational communities. Historically some industries
internationally have been more conflict-prone than others. They are
often characterised by a strong overlap between community networks
and employment networks. Examples would be mining, dock work
(as above), rail employment, prison officers and lumberjacks. Where
a community depends on a single industry or employer, disputes
with the employer often become disputes between the employer and
community. Unions become representatives of the community and union
membership becomes socially compulsory. This is known as the Kerr–
Siegel hypothesis. Again, it can operate at a micro level: even in large
metropolitan areas, organisations (such as the police or fire services)
that recruit serially from the same families can experience the same
effects.
• State ownership. Public sector union membership is much higher
than private sector membership in many economies. Several factors
are at work. First, the potential for disruption is considerable. Second,
the government often wishes to maintain employment standards as an
exemplar to the private sector. Third, organisational size is often very
large. Fourth, political decisions, rather than product market conditions,
often define employment terms and levels. Fifth, organisational aims
are essentially contestable: performance measures in public sector
organisations are often set with organisational objectives in mind that
are not fully shared by the employees subject to them. Put another way,
the employer benefit might not equate to a definition of the welfare
benefit of such organisations.
So we turn to the question of union decline. Employees want a voice. But
the key property they want is that the employer will listen and respond,
improving their relationship with the firm. Employers want a voice. But
they do not necessarily want the wage premium or the joint decision-
making involved in negotiating with unions. So it could become rational for
employers to reject the union voice and invest in their own. Consider Figure
4.4. This contains data from the UK.

35
Figure 4.4: Union and non-union voice
Source: Gomez et al., 2010.
Figure 4.4 is based on very comprehensive survey data and it covers
private sector employers. It is interesting data not only for the UK, but as a
test case on employer choice, since during the period covered there was no
legislation requiring employers to deal or not deal with unions. There was
also very little legislation requiring them to have any mechanisms within
the firm supporting voice. Three categories decrease. Two are related to
unions. Union-only voice, where the firm relies entirely on unions for voice
(as in the Freeman and Medoff (1984) argument), goes down most. Dual
voice, where managers use both union and non-union voice, declines, but
less rapidly. But, if we focus on the other two curves, we see that voice
mechanisms that the employer sponsors (non-union voice) expands, and
the sector where there is no voice contracts.
Firms want voice. They want mechanisms for feedback from employees to
managers. This leaves open what kinds of feedback occur and whether the
firm uses it to respond to employee concerns, but it is wholly inconsistent
with the separation of conception from execution at the heart of Taylorism,
and quite difficult to reconcile with the idea that firms are receptive to
perfunctory cooperation. There is substantial evidence from other Western
economies that employers find the need to engage with, learn from and
explain to those who work for them. The next chapter examines this more
closely.
Activity 4.2
Imagine you are the CEO of the organisation running the public transport system in the
city in which you live.What problems might unions cause you and what measures could
you take to deal with these problems?
So the final question to address is: what is the impact of this on theories
about management?
• Engagement of employees with the firms for which they work is
intrinsically problematic. An employment contract is initiated by a
firm in order to generate an outcome, which may be measured in a
variety of ways, as we shall see below, but will involve measures of
productivity, customer satisfaction, contribution to profit or a variety
of preferred measures. It may be accepted by an employee for many
reasons, but these reasons are likely to be both economic and non-
X
X X
X
Non-Union only
Dual voiceDual Voice
No Voice
Union-Only Voice
1984 1990 1998 2004
50
45
40
35
30
25
20
15
10
5
0
Union and Non-union Voice

36
economic. By this we mean only that there is overwhelming evidence
that employees want more from work than pay.
• This employment contract is incomplete, and in most Western
economies in the 20th century the employer would fill the ‘silences’
unless constrained by the state or by the collective organisation
of employees in a union. However, filling the silences involves a
‘command and control’ approach in only a minority of cases and
managerial practices to generate employee voice predominate even in
the absence of any compulsion for their use.
• outline the key features of the history of labour unions
• describe the potential benefits of unions to firms and employees
• discuss the reasons for union decline in modern industrial societies.
Why do workers join unions and why do employers negotiate with unions?

Chapter 5:The rise of human resource management
37
Chapter 5: The rise of human resource
management
• describe the history of personnel and human resource management
• discuss the content of human resource management approaches
• explain the relationship between human resource management and
organisational behaviour.
Willman, Chapter 4.
To complete Activity 5.2 you will also need to read:
Coyle-Shapiro, J.A-M. and M. Parzefall (2008) ‘Psychological contracts’
in C.L. Cooper and J. Barling (eds) The SAGE handbook of
organizational behaviour: volume 1. (London: SAGE Publications, 2008)
[ISBN 9781412923859], pp.17–34; available at: http://eprints.lse.
ac.uk/26866/1/Psychological_contracts_(LSERO).pdf
Baron, J. and D. Kreps Strategic human resources: frameworks for general
managers. (New York: John Wiley, 1999) [ISBN 9780471072539]
Chapter 2.
Becker, B. and B. Gerhard ‘The impact of human resource management
on organisational performance: progress and prospects’, Academy of
Management Journal 39(4) 1996, pp.779–801.
Tichy, N.M., C.J. Fombrun and M.A. Devanna ‘Strategic human resource
management’, Sloan Management Review 23(2,Winter) 1982, pp.47–61.
5.1.4 Works cited
Argyris, C. Understanding organizational behavior. (Homewood, Ill.: Dorsey
Press, 1960).
Bass, B.M. Leadership and performance beyond expectations. (New York: Free
Press, 1985) [ISBN 9780029018101].
Beer, M., B. Spector and P.R. Lawrence Managing human assets. (New York:
Free Press, 1984) [ISBN 9780029023907].
Colquitt, J.A., J.A. LePine and M.T. Wesson Organisational behaviour: improving
performance and commitment in the workplace. (New York: McGraw Hill,
2009) [ISBN 9780071318112].
De Menezes, L.M., S.J. Wood and G. Gelade ‘The integration of human resource
and operation management practices and its link with performance: A
longitudinal latent class study’, Journal of Operations Management 28(6),
2010, pp.455–71.
Dobbin, F., J.R. Sutton, J.W. Meyer and W.R. Scott ‘Equal opportunity law and
the construction of internal labor markets’, American Journal of Sociology
99(2) 1993, pp.396–427.
Ghoshal, S. and P. Moran ‘Bad for practice: a critique of the transaction cost
theory’, Academy of Management Review 21(1) 1996, pp.13–47.

38
Guillen, M.F. Models of management: work, authority and organisation in
a comparative perspective. (Chicago: Chicago University Press, 1994)
[ISBN 9780226310367].
Hamel, G. and C.K. Prahalad Competing for the future. (Harvard: Harvard
Business School Press, 1996) [ISBN 9780875847160].
Huselid, M.A. ‘The impact of human resource management practices on
turnover, productivity, and corporate financial performance’, Academy of
Management Journal 38 1995, pp.635–72.
Jurgens, U., T. Malsch and K. Dohse Breaking from Taylorism. (Cambridge:
Kotter, J. ‘What leaders really do’, Harvard Business Review, 68, 1990,
pp.103–11.
MacDuffie, J.P. ‘Human resource bundles and manufacturing performance:
Organizational logic and flexible production systems in the world auto
industry’, Industrial & Labor Relations Review 48 1995, pp.197–221.
Pfeffer, J. Competitive advantage through people (Boston: HBS Press, 1994)
[ISBN 9780875847177].
Rose, M. Industrial behaviour. (London: Penguin, 1988)
[ISBN 9780140091335].
Rousseau, D.M. Psychological contract in organisations: understanding written
and unwritten agreements. (Newbury Park: Sage, 1995) [ISBN to come].
Schein, E.H. Organizational psychology. (Upper Saddle River, NJ: Prentice-Hall,
1970) [ISBN 9780136411345].
Ulrich, D. The human resource proposition. (Harvard: HBR Press, 2005)
[ISBN 9781591397076].
Wall, T. and S. Wood ‘The romance of human resource management and
business performance and the case for big science’, Human Relations 58(4)
2005, pp.1–34.
Willman, P. and G. Winch Innovation and management control: labour
relations at BL Cars. (Cambridge: Cambridge University Press, 1985)
[ISBN 9780521268028].
Witzel, M. Builders and dreamers: the making and meaning of management.
(Harlow: Pearson, 2002) [ISBN 9780273654377].
Wren, D.A. The history of management thought. (New York: Wiley, 2005).
[ISBN 9780471669227].
Wright, P. M. and G.C. McMahan ‘Theoretical perspectives for strategic human
resource management’, Journal of Management, 18(2), 1992, pp.295–320.
Yukl, G.A. Leadership in organizations. (Upper Saddle River, NJ: Pearson/
Prentice Hall, 2006) [ISBN 9780138142681].
5.2 Introduction
Human relations thinking and the adoption of its techniques were
often associated with the creation of personnel departments. Guillen
(1994, pp.73–74) notes the rapid spread of personnel departments in
manufacturing in the USA in the second quarter of the 20th century. These
evolved into the modern human resources departments whose toolkit is the
human relations legacy. Second, there is an academic legacy. As Rose notes:
…technology supplanted the human relations climate as
the favourite variable for explaining human behaviour…
increasingly, investigators took the title of ‘organisation
theorists’. Combined with applied psychology, the sociology of
organisations formed the core of a newly popular and heavily
promoted academic area, organisational behaviour.
(Rose, 1988, p.81)
We shall look at both the practice of human resource management and
theories in organisational behaviour below.

39
In this section, we trace the lineage of the human relations approach
down to the 21st century. In fact, there are several legacies to consider. In
practical terms, we need to look at the evolution of the human resource
function within the firm. There are, of course, enormous variations in
human resource practice, but one may generalise to say that the concerns
of the human relations movement with the management of people have
been generalised into a set of practices employed by firms concerning
recruitment, retention, rewards, motivation and the commitment of
employees. In many firms there is a key departure from the spirit of the
human relations approach, in that human resource management (HRM)
is a staff function separate from line management; arguably this is a
central issue in how HRM works and we will discuss it both specifically,
in terms of the effectiveness of HRM, and generally, in terms of line-staff
arrangements within the firm. There is also an academic discipline called
HRM, which tends to focus on the design and effectiveness of individual
HRM practices and the performance implications for firms of combinations
or bundles of practices which involve intractable measurement problems.
The second legacy is the very sizeable academic field of organisational
behaviour (OB). Its theoretical agenda is similar to that of human
relations, but it is methodologically far more sophisticated, in part because
it has developed as a branch of applied psychology. It is not primarily
concerned with rationality – compared with economics rationality it is
treated as a variable not an assumption – and is not always concerned to
measure business outcomes such as efficiency or productivity. This chapter
seeks to illustrate rather than summarise this field and its contribution,
and it will do so by looking at how OB deals with two concepts which have
been central so far: hierarchy and contract. These emerge prominently in
the OB literature as studies of leadership and the psychological contract
respectively. We turn first to HRM.
5.3 The emergence of HRM
One of the most influential modern models of the practice of the HRM
function has been developed by Ulrich (2005). He argues for the
organisation of the function to be framed around three types of activity,
all of which support the actions of line managers in the management of
people in different ways.
1. Shared services is the set of basic administrative tasks in the
management of a workforce through which economies of scale may be
achieved by the concentration of activity on an enterprise-wide basis.
These activities include management of payroll, absence control and
employee databases more generally. The measures of performance of
such units are essentially the quality and timeliness of data provision
and cost. There are clear outsourcing possibilities, since inter-firm
scale economies can be exploited subject to confidentiality concerns
about employee data.
2. Centres of expertise focus on areas of knowledge where there may
also be economies of scale but where the complexity of information
required is such that line managers require support and advice where
relevant issues arise. Examples would be the selection of employees,
designing and applying reward systems (including pensions),
employee relations (including dealing with unions), training and
termination of employees. Compliance with relevant law is often
an issue in all such areas. Performance measures here are more
complicated, but would include, in addition to those for shared
services, some line management evaluation of quality of advice.

40
3. Business partnership involves small HRM teams working with high-
level line management to improve firm performance. Examples would
be issues such as strategy implementation, organisational design and
change management. The central ideas of HRM are central to the
business of the firm, assisting it to maximise its use of human assets.
Measurement problems here are intractable.
This is a simplifying, prescriptive and aspirational model, which
summarises both the activities a firm may require from its HRM function
and also the variance in relationships between line and staff. The shared
service and expertise activities essentially deal with, on the one hand, the
rise in bureaucratic employment issues within large firms and, second, the
regulatory burden on employment. The assumptions underlying business
partnership are qualitatively very different and are tied to a resource-based
view of the firm; they include the idea that the management of human
assets may be a source of competitive advantage. As Pfeffer puts it:
There is a substantial and rapidly expanding body of
evidence….that speaks to the strong connection between how
firms manage their people and the economic results achieved.
(Pfeffer, 1994)
The relevance of this model here is twofold. First, using this threefold
division is a useful heuristic for describing the development of HRM
practice historically. Second, as we shall see, it outlines the core tensions
within HRM practice. Let us look at each in turn.
Two early and uncorrelated developments are noteworthy. First, in some
large 19th-century firms, ‘welfare’ departments were established that
were concerned with the provision of canteens, medical services, housing
and, in some cases, social work. This was particularly strong in Germany.
In the UK it was associated with philanthropy by owners whose concerns
were religious or social, rather than economic, for example Cadbury, the
confectioner, and Wedgewood, in ceramics. The earliest recorded such
department in the USA was the National Cash Register Company in 1897
(Wren, 2005, p.186). Retrospective cynicism might see in these ventures
the pursuit of business objectives – for example, seeing the company
doctor might be seen as a form of absence control – but there is probably
also a genuinely altruistic interpretation, and no systematic evidence of
cost-benefit analysis in the well-documented examples such as Cadbury.
Slightly later, more focused activities were driven by the workforce quality
needs of scientific management: selective hiring, incentive pay and
absence control were all central to the pursuit of efficiency. If this pursuit
generated recourse to trade unions by employees, a set of bargaining
and consultation arrangements needed to be designed and monitored. In
addition, as Gospel notes:
Over time, in most countries, there has been a gradual build up
in (government) intervention in terms of rights off the job (state
welfare and pension systems), rights on the job (workmen’s
compensation, health and safety, racial and sexual equality
legislation) and regulation of collective employment matters
(the law on trade unions, collective bargaining and information
and consultation at work).
(Gospel, 2007, p.423)
These tendencies came together in the post-First World War period in
many firms and countries in the formation of a ‘personnel department’,
which was essentially a lubricant to the bureaucratic employment
relationship providing shared service and expertise-type functions to line

41
management. As such, it tended towards reactive response and problem
solving according to a line-management agenda, or in order to ensure
compliance with external rules. This should not lead to a view of the
personnel department as marginal. For example, Dobbin et al. (1993)
argue that a combination of equal opportunity law and the power of the
personnel function is a better explanation for the spread of internal labour
market structures in the USA than is the efficiency argument. But the role
did not include the strategic elements Ulrich (2005) identifies.
The major change to what we now characterise as HRM came in the 1970s
and 1980s, first in the USA. It required several intellectual developments
elsewhere and, as is frequently the case, a sharp shock and an opportunity.
First, if HRM were to influence strategy, somebody had to be ‘doing’
strategy explicitly. As we show below, the academic study of business
strategy was a relatively late arrival, and even early versions such as
strategic planning post-date the emergence of personnel departments. But,
second, the role of the management of people as an element in strategy
needed to be articulated in a particular form – the resource-based theory
of the firm. Once this intellectual toolkit was in place, and employees
could be seen as a source of competitive advantage, the stage was clear for
HRM to make a bid to be strategic.
The sharp shock was provided by the emergence of Japanese competition
in the 1980s and in particular the use of what became described as high-
performance work practices within systems. Consummate cooperation
required HRM technique. The opportunity was provided by the removal of
a constraint − the decline of trade unionism. The language of personnel
management changed. An influential text was Beer et al.’s Managing
human assets, embedding the idea that ‘people are an asset not a cost’
and thus the HRM function needs to be ‘fully aware of and involved in all
strategic and business decisions’ (Beer et al., 1984, p.292). HRM became
strategic – defined as the ‘pattern of planned human resource deployments
and activities intended to enable an organisation to achieve its goals’
(Wright and McMahan, 1992, p.298). And the idea resonated among
popular strategy authors:
The way we organise our business and leverage our intangible
assets, primarily vested in people, is one of the most
fundamental and sustainable sources of competitive advantage.
(Hamel and Prahalad, 1996)
Three central issues emerged to beset this literature. First, what were
these HRM practices that one deployed in order to generate competitive
advantage and how did one deploy them? Second, were these practices
the same everywhere? If firm strategies were different, were different
bundles of HRM practices required to deliver them? Third, how could one
measure the impact of HRM practices on competitive advantage? We look
at each in turn.
Pfeffer (1994) offers seven generic (universally applicable) practices for
building profits by ‘putting people first’. They are:
1. employment security
2. selective hiring
3. self-managed teams or team working
4. high pay contingent on company performance
5. extensive training
6. reduction of status differences
7. sharing information.

42
This is an influential list but it is not the only list in play. Meta-analysis
of the field (Wall and Wood, 2005) shows a variety of different items
listed as HRM practices across a variety of studies. There is no widespread
agreement on what should be included or excluded. So there is not a
‘theory’ of HRM and performance here. It is not clear whether the effects
of these practices on performance would simply be additive or whether,
in particular combinations, the whole would be greater than the sum
of the parts. Some empirical studies around the relationship between
these kinds of practices and performance variables generate very specific
numbers; Huselid (1995), for example, argued that a dollar value of firm
benefit could be identified for unit value increases in HRM use. However,
the path by which these practices generate outputs remains obscure. The
proposition that any firm adopting any HRM practice or set thereof will
generate a performance improvement is weak. As Macduffie has remarked:
Innovative human resource practices are likely to contribute to
improved economic performance only when three conditions
are met: when employees possess knowledge and skills that
managers lack, when employees are motivated to apply this
skill and knowledge through discretionary effort; and when
the firm’s business or production strategy can only be achieved
when employees contribute such discretionary effort.
(Macduffie, 1995, p.199)
However unattractive the Taylorist model of the excellent worker
might be, it contains a model of the relationship between labour
input, production process, output and reward that studies of the HRM
performance link have so far failed to generate. This is, of course, partly
because the unit of analysis for Taylor is the individual, while that for
HRM studies is variable.
The second issue concerns inter-firm variation; if strategies are different,
maybe HRM practices need to be. Wall and Wood (2005, p.431) identify
three types of ‘fit’ between HRM practices and the firm.
1. Internal fit ‘posits synergy among the practices, meaning that their
collective effect will be greater than the sum of their individual parts’.
2. Organisational fit ‘concerns the role of HRM in enhancing the
effectiveness of other organizational practices or technologies, and vice
versa’.
3. Strategic fit ‘assumes that HRM practices need to be aligned with
the organization’s strategy to have their full effect on performance’.
The first concept of fit suggests that some combinations of HRM practice
may be better than others. The second implies that some combinations
may optimise the performance of certain technologies. But the third
reaches to the heart of Ulrich’s idea about the organisation of the HRM
department and its relationship to line management. For Ulrich, the
essence of competitive advantage from HRM is the HRM–line management
relationship, rather than a bundle of practices. The bundle of practices is a
dependent variable. Let us look at the line management−staff relationship.
Witzel (2002, pp.51–54) offers an interesting set of observations. First, he
notes that the line management−staff division, which became common
practice and parlance in the business world, originated in military
organisation. He uses the Prussian army in the 19th century as an example.

43
Second, he noted that the line management units had to be Taylorist and
the staff units had to coordinate, integrate and be goal-focused. Third,
he offers a specific example: the Franco-Prussian war of 1870 when less
well armed and less experienced Prussian troops defeated an apparently
superior French army by virtue of the line management−staff relationship
that generated flexibility and rapid response. Fourth, he observes that a
prominent early management theorist, the American Harrington Emerson,
observed this conflict directly and incorporated his views of it in his
writings. The core issue that links 19th-century military operations and
21st-century management of people in organisations is the observation that
an organisational attribute, rather than a capital or resource asset, can be
the source of competitive advantage and, moreover, that organisations that
are asset-poor can outcompete those that are asset-rich.
The third problem is of a rather different nature. Whatever the claimed
impact of HRM practices on a dependent variable such as performance,
it is still unclear whether any competitive advantage is being generated.
If, as many authors have implied, effective management of human assets
leads to competitive success, it is necessary to show that these ‘bundles’ of
practices can be better implemented by some firms than others. There has
been little analysis of this. In the car industry example used above, the key
performance variable ‘man hours per car’ has fallen across the industry, in
part as a consequence of the adoption of high-performance work practices,
but this can simply generate a price war rather than a competitive
advantage (Jurgens et al., 2003; Willman and Winch, 1985).
De Menezes et al. have used data on both operations management practice
and the use of HRM in a longitudinal study that indicates the way forward
in this field. They show that firms that innovate early and integrate HRM
with production practices generate sustained performance improvement,
arguing:
An integrated managerial philosophy is potentially a source
of competitive advantage, highlighting the importance of
continuous improvement and learning that is often allied to the
lean production concept.
(De Menezes et al., 2010, p.1065)
So, in the HRM field, it does not seem that simply adopting a practice or
set of practices employed by a successful competitor offers a high chance
of replicating their success. Many firms in many sectors do so for both
practices and for targets, in a process known as ‘benchmarking’. As we
have seen, we may improve an aspect of our own firm’s performance by
adopting ‘best practice’ but it may not improve relative performance.
Methodologically, it involves sampling on the dependent variable which
can give rise to unexpected, often disappointing, results. In the HRM field,
many studies even use cross-sectional data to study allegedly causal HRM
performance relationships; these methods cannot discriminate effectively
between firms that might be improving performance using HRM and firms
that have improved performance so can afford the investment of HRM.
Activity 5.1
Find the organisations chart for a large firm of your own choice on the web.Try to identify
line and staff functions.

44
5.4 Organisational behaviour
This has recently been influentially defined as:
A field of study devoted to understanding, explaining, and
ultimately improving the attitudes and behaviours of
individuals and groups in organizations.
(Colquitt, LePine and Wesson, 2009, p.7)
Let us deal with the omissions from this definition first. Organisational
behaviour (OB) academics are not primarily concerned with firms, or firm
performance, and they seldom study markets. The disciplines on which
OB draws – psychology and social psychology – are deployed in markets
by others (looking at consumer behaviour, see below) but these literatures
have emerged separately. The field looks at affective states as worthy of
study in themselves, and generates sophisticated models to relate affective
states and behaviours. It is highly fragmented, with no core body of
theory delineating a model of human behaviour comparable to economic
man, and it is arguably held together by rather looser assumptions and a
commonality of method.
Two sub-fields illustrate how this field differs from one that makes
assumptions about rationality and self-interest. Economic approaches
use principal–agent theory to describe hierarchy, while OB talks about
leadership. Economists describe employment contracts as incomplete,
whereas OB academics study how these silences are filled. We look at
each in turn, as illustrations of the difference between rational choice and
psychological approaches to organisation.
Figure 5.1: The history of leadership studies
Consideration of leadership precedes the business literature on the
subject by centuries, with much of the literature concerned with military
leadership. The academic literature emerges in the 1920s and the unit
of analysis is the individual; leadership is about traits possessed by
individuals, which may be innate (dispositional) or acquired (through
experience). Trait theory is fundamentally depressing for the business
literature because it implies that efforts to improve the quality of
leadership in an organisation must be limited to appropriate selection
of staff. The historical development of the literature away from this (see
1920s 1930s 1950s 1970s CURRENT
Followership
Leader
Member
Exchange
Contingency
Theory
Style
Theories
Trait Theory
Personality,
skills
Generic skill
sets
Tasks, power,
uncertainty
Relationships
trust
Needs, values
performance

45
Figure 5.1) may be viewed as an attempt to embrace an increasing array
of organisational variables in order to understand how leadership may be
developed or enhanced within particular contexts.
Sensitivity both to the idea of leadership as an attribute of a finite set of
persons and, more generally, to any notion of innate advantage was high
in the West between the demise of the Third Reich and the discovery
of DNA (which was to provide a language for discussion of genetics).
Leadership became about behaviours that individuals could practise,
although it was acknowledged that different individuals might practise
them to different degrees. The approach was developed in the Midwest
of the USA. Studies by Ohio State University identified two categories of
leadership behaviour:
1. consideration: develop relationships of mutual trust, respect for
followers’ ideas, regard for their feelings
2. initiating structure: define and structure own role and those of
followers.
These behaviours could score either high or low and were independent
of each other, but it was claimed that the most effective leaders came up
high on both. The research was based on questionnaires to leaders and
subordinates. The Michigan Leadership Studies began in the 1950s and
indicated that leaders could be classified as either ‘employee centred’ or
‘job centred’. Twin categories of ‘task’ and relationship behaviours – similar
to the Ohio studies – were identified which were theoretically orthogonal
but empirically associated with being ‘high’ in the most effective
behavioural pattern.
These two categories have, in modified form, very wide currency in the
management literature being used in the analysis of teams and teamwork
at the micro level, and organisational culture at the macro level. They
replicate in this literature the broad engineering concern for efficiency
and the human relations concern for work relations. It is thus worth
mentioning that direct measures of efficiency were not taken in these
large-scale sets of studies.
Although these studies used questionnaires from subordinates, they
were still generic in arguing for leadership behaviours independent of
either context or audience. The next two developments in leadership
research addressed each in turn. Contingency theories suggested sources
of variation in leadership effectiveness based in the power of the leader,
the nature of the task to be completed and level of uncertainty in the
work situation. Subsequent theories placed more emphasis on the leader–
follower relationship as the unit of analysis; leader–follower relationships
were variable, but patterned, and follower reactions to leadership
became increasingly the most significant dependent variable. In a modern
definition:
Leadership is the process of influencing others to understand
and agree about what needs to be done and how to do it, and
the process of facilitating individual and collective efforts to
accomplish shared objectives.
(Yukl, 2006, p.10)
Increasingly, the desired outcomes of leadership were seen to be followers’
emotional states and the behaviours associated with them. Increasingly,
too, the leadership behaviours seen to be associated with such states and
behaviours were distanced from monitoring and incentives. A simple
interpretation of what an effective economic ‘principal’ should do, would
be ‘bad leadership’ in the OB literature. A corollary of this is that many

46
writers on organisations treat the combination of monitoring, incentives
and discipline as likely to generate precisely the outcome it was intended
to avoid (Ghoshal and Moran, 1996). Leadership is a set of behaviours
performed independent of hierarchical position.
A pervasive theme in the literature contrasts ostensibly rational activities
around monitoring and exchange relationships with those focused more on
affect. For example, Bass (1985) distinguishes transactional leaders who
motivate employees through an exchange process involving rewarding
and correcting, from transformational leaders who motivate employees
by activating their higher order needs, offering inspiration, intellectual
stimulation and individualised consideration. Using different language
but basically the same dichotomy, Kotter (1990) distinguishes managerial
activities such as planning, budgeting and controlling – the business
of ‘coping with large organisations’ – from leadership activities such as
setting direction, providing vision and inspiration and building teams. In
more modern versions, ideas such as ‘authenticity’ and ‘charisma’ are used
to describe effective leadership.
5.5 The psychological contract
Sociologists have long been interested in exchange. But these social
exchange theorists tended to take a broader view than simple economic
exchange. Resources, both tangible and intangible, are included and there
needs to be some notion of balance. Social exchange is voluntary and
continuing, but it entails unspecified obligations about the exact nature
of reciprocity. Where social exchange continues, norms of reciprocity are
established, such that people both help and avoid injuring those who have
helped them. Continuing reciprocity generates trust between exchangers,
which may provide the basis for enduring and profitable network linkages.
Trust relations have dynamics, such that trustworthiness is rewarded and
its loss can lead to a cycle of mistrust.
One important strand of OB develops this line of thought to analyse
employment relationships: psychological contract research. Again, the
human relations movement is in the lineage. Argyris (1960) used the term
‘psychological work contract’ to describe a Hawthorne-type relationship
between informal work groups and managers involving a trade between
stable wages and employment security for the former, and higher
productivity and fewer grievances for the latter. The cognitive elements in
this approach were refined by Schein (1970) in a focus on the matching
of expectations and exchange performance where each party might have a
different set of both preferences and perspectives.
But the defining approach that has generated the bulk of research on the
matter is from Rousseau. She defines a psychological contract as:
Individual beliefs (sic), shaped by the organisation, regarding
terms of an exchange agreement between individuals and their
organisation.
(Rousseau, 1995, p.9)
The content of the contract involves both tangible and intangible
elements; a considerable segment may be ‘promise-based obligations’
made by one party concerning long-term commitments to the other, and
these promises themselves may be both implicit and explicit. While there
is much debate and critique about the definition of constructs, it is clear
what the objective is here: to capture the sum of the relationship between
employee and employer where that relationship involves, for the employee

47
at least, a massively significant social exchange where both economic
interests and psychological concerns are embraced. The former is captured
by the notion of a transactional contract, typically short-term economic
exchanges with limited emotional investment. The latter is captured by a
second dimension − the relational contract − where both parties make
considerable idiosyncratic investments.
Psychological contract breach – termed rather emotively ‘violation’ – is
both significant and common; employees, at least, quite frequently
perceive violation in terms of broken promises and studies have indicated
consequences, depending on the seriousness of the breach (or its
perception), in terms of lowered satisfaction or commitment, or even
absence and exit. Breach appears to have a bigger downside impact than
contract fulfilment has as an upside, and Rousseau herself (2005) appears
to see them as independent constructs rather than as a dichotomy or
continuum; employees report both fulfilment and breach coexisting within
the same contract. Repeated breach generates a shift from a relational to a
more transactional contract.
The approach has been criticised. Rousseau appears to focus primarily on
the employee, a tendency reinforced by over-reliance on her graduating
MBA students as research subjects. However, even if it is only a theory
of employee behaviour, it has substantial scope. It is not particularly
helpful to management practice, since the circumstances under which an
individual generates a psychological contract involve individual difference
variables and are quite idiographic. But it does quite clearly allow one
to fill in the silences in the employment contract noted by Williamson.
Moreover, it stresses the social and psychological factors that allow for
the effective operation of highly incomplete contracts in ways that help to
understand the impact of affect on contract performance.
There are clear links to institutional economics, not least the distinction
between relational and transactional contract dimensions. Rousseau
herself explicitly uses Hirschman’s exit-voice model in explaining
responses to violation (1995, p.134). And many violations develop out of
what are fundamentally agency problems: promises are made by recruiters
or line managers who then leave the organisation, which in turn neither
recognises nor honours the perceived promise. However, at the most
fundamental level, similarity is assured by the fact that the psychological
contract approach is a bounded rationality model.
We can elaborate on this by looking at how individuals construct
contracts. Rousseau suggests that individuals have contract schema:
prototypical mental models about how contracts work. These are rooted in
‘predispositions’, then based on work history and develop by accumulating
information about contract obligations in work settings. Typically new
entrants have incomplete information about the organisation, and
Williamsonian problems about the construction of complicated contingent
claims contracts that cover future contribution and reward. Information
cues originate with co-workers or managers, and information search and
processing is discontinuous – higher where there may be contract violation.
Once formed, they have heuristic characteristics; they frame information
search and are resistant to change (Rousseau, 1995, pp.27–36; 2001).
Activity 5.2
Read the first and last chapters of the Rousseau book or the article by Coyle-Shapiro
and Parzefall. List why the ‘breach’ of a psychological contract might be important for an
employer.

48
This chapter has tried to trace the human relations legacy down to more
modern theories (OB) and practices (HRM). At the most fundamental
level, both are concerned to explore or manage the non-rational side
of organisations, or at least the interactions between rational and non-
rational. OB is based on the premise that it is intrinsically worthwhile
to study attitudes and behaviours in organisations independent of any
concerns with measures of performance. HRM is based on the premise that
one can apply this knowledge to how people are managed in organisations
in order to improve performance.
• describe the history of personnel and human resource management
• discuss the content of human resource management approaches
• explain the relationship between human resource management and
How would you account for the rise of the human resource function within
large firms?

Chapter 6:The origins of management science
49
Chapter 6: The origins of management
science
• describe quantitative modelling approaches to operations management
• explain the basic concepts of queuing systems, inventory control and
linear programming
• discuss some of the challenges facing the implementation of these
management science concepts.
Hopp, W.J. and M.L. Spearman Factory physics. (New York: McGraw-Hill, 2007)
[ISBN 9781577667391] Chapter 2, pp.48–56.
Ackoff, R.L. ‘The future of operational research is past’, Journal of the
Operational Research Society 30 1979, pp.93–104.
Hillier, F.S. and G.J. Lieberman Introduction to operations research. (New York:
McGraw-Hill, 2004) [ISBN 9780071238281].
Kirby, M.W. ‘Operations research trajectories: the Anglo-American experience
from the 1940s to the 1990s’, Operations Research 48 2000, pp.661−70.
Mitchell, G. The practice of operational research. (Chichester: Wiley, 1993)
[ISBN 9780471939825].
Pidd, M. Tools for thinking: modelling in management science. (Chichester: Wiley,
2003) [ISBN 9780470847954].
6.1.4 Works cited
Ackoff, R.L. and M.W. Sasieni Fundamentals of operations research. (Hoboken,
NJ: John Wiley & Sons, 1968) [ISBN 9780471003335].
Bixby, R.E. ‘Solving real-world linear programs: a decade and more of progress’,
Operations Research 50 2002, p.1.
Dantzig, G.B. ‘Linear programming’, Operations Research, 50(1), 2002, pp.42–47.
Gross, D. and C.M. Harris Fundamentals of queueing theory. (Chichester: Wiley,
1998) [ISBN 0471170836]. (Wiley Interscience, 2008) fourth edition
[ISBN 9780471791270].
Morse, P.M. and G.E. Kimball Methods of operations research. (Cambridge,
Mass.: Technology Press of MIT, 1950).
6.2 Introduction
Taylor’s aspiration (discussed in Chapter 3) was to develop a scientific
management based on the universal application of certain principles.
However, Taylor’s ideas were technological rather than truly scientific. One
outgrowth of scientific management was management science (MS).
Here are three definitions:
1. a scientific method of providing executive departments with
a quantitative basis for decisions regarding the operations
under their control. (Morse and Kimball, 1950)

50
2. (1) the application of scientific method (2) by
interdisciplinary teams (3) to problems involving the control
of organized (man-machine) systems so as to provide
solutions which best serve the purposes of the organisation
as a whole. (Ackoff and Sasieni, 1968)
3. The attack of modern science on complex problems arising
in the direction and management of large systems of men,
machines, materials and money in industry, business,
government and defence. Its distinctive approach
is to develop a scientific model of the system,
incorporating measurements of factors such
as change and risk, with which to predict and
compare the outcomes of alternative decisions,
strategies or controls. The purpose is to help
management determine its policy and actions scientifically.
(S. Beer, Operational Research Quarterly, 1963, p.282)
MS often works by the construction of models that are external and
explicit representations of part of reality as seen by the people who wish
to use that model to understand, to change, to manage and to control that
reality (Pidd, 2003, p.12). Figure 6.1 below elaborates. The inputs to the
model are our beliefs and assumptions about reality and the scenarios
we wish to play out. The outputs are insights on the way firms work and
estimates about quantities.
Beliefs
Assumptions
Scenarios
Insights,
Estimates of
quantites of
interest
Model
Figure 6.1: The role of a model
We will illustrate this approach by looking at three classic examples of
operations research (OR)/MS:
1. inventory management
2. telephone networks
3. military planning.
Then we will turn to the post-war development of management science.
6.3 Inventory management
The issue we wish to deal with here is as follows. A company
(manufacturer, retailer) has to place orders for some goods. How often
should they order and how big should their orders be?
We formalise this as follows:
D demand rate (in units per year)
c unit production cost (in £)
s fixed setup cost (in £)
h holding cost (in £ per unit per year)
Q lot size (in units)

51
2
( ) 2
0
2
DC Q h sD sD
Q
DQ Q h
= − = → = (1)
Let us suppose that:
• We only order product when we run out.
• We will order enough to meet demand.
The total cost is as in equation 1 above:
We need to be clear about what assumptions we are making here.
• cD does not vary with Q
• Let’s set c=0 and plug in some numbers as follows:
D 1000
s £500
h £35
0
5000
15000
25000
10000
20000
30000
10
30
50
70
90
110
130
150
170
190
210
230
250
290
330
370
270
310
350
c(Q)
sD/Q
hQ/2

Figure 6.2: Curves for holding costs, fixed setup costs and unit production costs
We set holding cost and order cost equal. The curves are as in Figure 6.2.
2 3
!
1 ...
1! 2! 3! !
n
n
nBB
n
λ
λ λ λ λ
=
+ + + + +
(3)
2 2 2
2
hQ sD sD sD
Q Q
Q h h
= → = → = (4)
( )
1
µ λ−
(2)

52
Alternatively, differentiate c(Q):
This formula is the economic order quantity formula.
What does this tell us? First, it gives us a basis for computing lot sizes (if
the assumptions are satisfied). Second, it gives us insight into a key trade-
off between holding and ordering costs.
6.4 Telephone networks
6.4.1 The advent of queueing theory
A.K. Erlang, a mathematician working for the Copenhagen Telephone
Company, was interested in applying probability to understanding lost
calls in telephone networks.
Let us suppose:
• a telephone exchange has n lines
• a telephone call lasts for one time unit
• λ calls arrive per unit time, according to a Poisson process.
A Poisson process is a continuous time, discrete state stochastic process
with a continuous rate of increase which is independent of the process’s
history. It is commonly used to model arrivals of large numbers of
customers who act independently.
Erlang was able to show that the probability of a call arriving and finding
all lines in use (and consequently, the call being ‘lost’) is:
Erlang’s work stimulated a general theory of queueing, as follows.
Suppose:
• a number of randomly arriving customers seek a service with rate λ
• a number of servers process these customers with rate μ .
We are interested in the three following questions:
4. How many will be turned away?
5. How long will customers wait?
6. How long will waiting times be?
With one server, and assuming demand arrives according to a Poisson
process and that service times are exponentially distributed, then, in
steady-state, assuming μ >λ, the mean time for the customer’s journey will
be:
(Gross and Harris, 1998)
The formula ρ = λ /μ is called the ‘traffic intensity’.
Let us see what happens if we increase the speed of the system, holding
traffic intensity constant.
2
( ) 2
0
2
DC Q h sD sD
Q
DQ Q h
= − = → = (5)
B =
1
1 2! 3!
λ λ2
λ2
λn
λn
n!
n!
+ + + + +…
(1)
( )
1
µ λ−
(2)

53
Figure 6.3: Queueing theory: an illustration
For ρ=5/6
As Figure 6.3 shows, as the system scales up, it becomes more ‘fluid’ and
waiting time diminishes.
Queueing theory is a massively general theory with applications to:
• telecommunications
• manufacturing facilities
• passenger transportation
• supply chains
• retail outlets
• healthcare systems
• law courts
• back office functions.
Activity 6.1
Visit a supermarket near you, ideally at a busy time. How do they manage the queues at
the checkout?
6.5 Military planning
Inventory management and queueing theory are early examples of
the success of management science, but the field was given immense
impetus by the involvement of civilian scientists seconded to the analysis
of military operations. ‘Operations analysis’ was used in determining
operational policy against submarines in the Battle of Britain, the D-Day
landings and Allied bombing campaigns. After 1945, many of the insights
from this experience were to become important civilian applications. A
good example is the development of linear programming.
George Dantzig, a mathematician, had spent the Second World War in the
Pentagon. He had become interested in mechanising the planning process
and his work was to leave OR/MS with one of its most important tools
– linear programming. A linear programming problem runs as follows.
6
5
4
3
2
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
pedestrianscars
Journey
time
(holding
traffic
intensity
constant)
λ (arrival rate, customers per unit time)
trucks Service time
Waiting time

54
Consider the problem of assigning 70 people to 70 jobs. Suppose a value
or benefit vij would result if the ith person is assigned to the jth job. An
activity consists in assigning the ith person to the jth job. The restrictions
are:
i. each person must be assigned to a job (there are 70 such)
ii. each job must also be filled (also 70).
The level of an activity is either 1, meaning it will be used, or 0, meaning
it will not.
Thus there are or 140 restrictions, or 4,900 activities with 4,900
corresponding 0–1 decision variables xij. Unfortunately there are ‘70
different possible solutions or ways to make the assignments’ (Dantzig,
2002, p.42).
This sort of mathematical object:
Or, in matrix notation:
Maximise vw
by varying x
subject to Ax ≤ b
and x ≥ b
consisting of a quantity to be maximised or minimised (an ‘objective
function’) by varying certain other quantities (‘decision variables’) subject
to certain restrictions on the combined values of the decision variables
(a ‘constraint set’) is called a ‘mathematical program’. Dantzig was to
discover a method for practically and efficiently computing the solution to
such problems.
Maximise 150x1
+ 250x2
subject to
x1
≤ 4 (1)
x2
≤ 6 (2)
3x1
+ 3x1
≤ 18 (3)
5x1
+ 4x1
≤ 40 (4)
x1
, x2
≥ 0 (5)
Another example of linear programming runs as follows.
You run a tailoring business. There is demand for up to 400 formal dresses
at £150 each and 600 suits at £250 each. You have 1,800 hours’ labour. It
requires:
• three hours for a dress
• two hours for a suit.
Maximise
by varying the xij
s
subject to the constraints
∑ ∑
m m
i=1 j=1
vij
xij
∑
m
j=1
xij
= 1
∑
m
i=1
xij
= 1
xij
= 0 or 1

55
You have 4,000 yards of material:
• a dress takes five yards
• and a suit takes four yards.
You have already paid for labour and material and have no alternative
uses for them. How might you find the revenue-maximising number of
dresses and suits to produce?
0
2
4
6
8
10
2 4 6 8 100
x2
x1
(2)
(4)
(3)
(5)
(1)
Figure 6.4: An example of linear programming
The decision variables x1 and x2 represent, respectively, hundreds of
dresses and suits. Constraints (1) and (2) represent the constraints
imposed by demand (at the price you have set). Constraints (3) and (4)
represent constraints imposed by labour and material respectively. The
remaining constraints (5) are required to ensure that you do not produce
negative quantities of dresses and suits.
In 1947, Dantzig’s simplex algorithm was applied to a ‘diet problem’.
The problem was huge for the time – nine constraints and 77 variables.
Arriving at the optimal solution by manual calculators took 10 people
120 days. As long as calculations had to be done by hand, mathematical
tractability imposed serious constraints. Data availability and quality
severely limited opportunities for modelling.
The most intuitive way to model a system is to simulate. In the decades
after the war, hand simulation gave way to computer simulation. And
computer simulation packages have become steadily more user-friendly,
visual and interactive.
Moore’s law describes how computing power doubles every two years, but
the speed of LP codes has increased much faster than that. Bixby (2002)
reports an LP with 5 million rows and 7 million columns (variables)
solvable in half an hour. Very complex problems (e.g. airline crew
scheduling) are now practically solvable.
Activity 6.2
You own an aeroplane with 200 seats.You wish to fill all those seats, at the highest
revenue possible, on the next flight.What actions can you take to ensure this?

56
This chapter looked at the development, post-Taylorism, of quantitative
modelling approaches to operations management. Basic concepts of three
broad areas of management science – inventory control, queuing systems
and linear programming –were introduced and their core insights and
propositions examined.
• describe quantitative modelling approaches to operations management
• explain the basic concepts of queuing systems, inventory control and
linear programming
• discuss some of the challenges facing the implementation of these
management science concepts.
What factors influence a firm’s decision about how much inventory to
hold?

Chapter 7:Accounting, finance and the firm
57
Chapter 7: Accounting, finance and the
firm
• describe four different perspectives on the firm with the purpose of
comparing their approach to accounting and finance
• discuss the principal–agent model
• explain the differences between economic and sociological models of
the firm.
Willman, Chapter 2, Theme 1.
Watts, R. and J. Zimmerman Positive accounting theory. (Englewood Cliffs, NJ;
London: Prentice-Hall 1986) [ISBN 9780136861713] Chapter 1.
Jensen, M. ‘Organization theory and methodology’, The Accounting Review
58(2) 1983, pp.319–39.
Jensen, M.C. and W.H. Meckling ‘The theory of the firm: managerial behaviour,
agency costs and ownership structure’, Journal of Financial Economics 3
1976, pp.305–60.
Miller, P. ‘Accounting as social and institutional practice: an introduction’
in Hopwood, A. and P. Miller (eds) Accounting as social and
institutional practice. (Cambridge: Cambridge University Press 1994)
[ISBN 9780521469654].
Rajan, R.C. and L. Zingales ‘The firm as a dedicated hierarchy: a theory of the
origins and growth of firms’, Quarterly Journal of Economics 116(3) 2001,
pp.805–51.
Simon, H. ‘A behavioural model of rational choice’, The Quarterly Journal of
Economics 69(1) 1955, pp.99–118.
7.1.4 Works cited
A.V. Bhidé The origin and evolution of new businesses. (Oxford: Oxford
Burchell, S., C. Clubb, A. Hopwood, J. Hughes and J. Nahapiet ‘On the roles
of accounting in organizations and society’, Accounting, Organizations and
Society 5(1) 1980, pp.5–27.
Chapman, C.S., D.J. Cooper and P.B. Miller (eds) Accounting, organizations
and institutions: essays in honour of Anthony Hopwood. (Oxford; New York:
Oxford University Press, 2009) [ISBN 9780199546350].
Jackson, T. Inside Intel: Andrew Grove and the rise of the world’s most
powerful chip company. (New York, NY: Dutton Books, 1997)
[ISBN 9780525941415].
Mackenzie, D. An engine, not a camera: how financial models shape markets.
(Cambridge: MIT Press, 2006) [ISBN 9780262633673].
Rajan, R.C. and L. Zingales ‘Financial dependence and growth’, American
Economic Review 88(3) 1998, pp.559–86.
Weetman, P. Financial accounting: an introduction. (Harlow: Pearson, 2013)
sixth edition [ISBN 9780273789253].

58
Zingales L.G. ‘In search of new foundations’, The Journal of Finance 55(4)
2000), pp.1623–53.
7.2 Background: definitions of accounting and finance
The following definitions are relevant for this and future chapters.
• We take finance to mean the different ways in which firms raise
capital for the operation of the firm.
• We take accounting to mean the conceptual frameworks through
which principals monitor the activities of their agents.
See also Weetman (2013) for further definitions.
7.3 Principal–agent theory
The principal–agent model operates with assumptions about behaviour
and stylised actors as follows.
1. There are two sets of actors in the firm. Principals are the shareholders
in the firm and agents are the managers.
2. Actors aim to maximise their individual utility.
3. The agent acquires information that is not available to the principal
and consequently may act against the interests of the principal.
4. This generates information asymmetries which are the basis of moral
hazard.
5. The principal monitors the agent to prevent this.
6. The purpose of monitoring is to exercise control over the agent by
acquiring information about the agent’s actions.
7. Principals compare the benefits and costs associated with each
outcome and are unconstrained in their ability to compute infinite
amounts of information.
8. Principals seek to achieve an optimal solution in which production is
maximised.
The firm is seen as a nexus of contracts between principals and agents
(Jensen and Meckling, 1976). The focus is on the contractual relations
between self-interested individuals with divergent interests. Agency
generates costs. These costs are the sum of the costs of structuring,
bonding and monitoring contracts between agents. The purpose of
monitoring is to exercise control over the agent by acquiring information
about the quality of the agent’s actions. Maximising agents minimise
the costs in any contracting relationship. Consequently, whichever
organisational form emerges reflects a set of contractual arrangements
that minimise agency costs.
Here is an example from the field of pension fund management, where
there is an ‘accountability deficit’. The principals in a pension fund are
those, normally employers and employees, who make contributions to
the fund which are then invested on their behalf. There are at least three
layers of actors whose interests may conflict with those of principals.
First, investment consultants monitor the investment performance of fund
management firms and advise on the selection of fund managers. Second,
those fund management firms invest the pension fund’s assets on a daily
basis. Third, the lawyers to the pension fund advise on the selection of
an investment consultant. For the principals, the monitoring costs are
potentially high and, since these agents have different types of expertise,
monitoring is difficult.

59
Here is another example. Intel was established when Robert Noyce,
general manager of Fairchild Semiconductor, and Gordon Moore,
head of research at Fairchild Semiconductor, left Fairchild to form
Integrated Electronics. Shortly before their departure, a scientist in
Moore’s department discovered the ‘silicon gate’ technique to produce
semiconductor memory devices. Intel subsequently became the market
leader in producing such devices. As Jackson remarks, ‘Intel was founded
to steal the silicon gate process from Fairchild’ (1997, pp.26–27). This type
of development was not uncommon in the dot.com boom. Seventy-one of
the firms included in the Inc. 500 list of young, fast-growing firms were
founded by people who replicated or modified an idea encountered in
their previous employment (Bhide, 2000, p.94).
Let us look at the dynamics more formally.
1. Horizontal hierarchy
2. Vertical hierarchy
Watchmaker
RamPietro
Watchmaker
Pietro
Ram
Figure 7.1: Horizontal and vertical hierarchies
Figure 7.1 shows an example of a horizontal hierarchy. Let us assume
that managers specialise and that, in specialising, each manager gets
half of what he produces and half of what the managers below him
produce. (The most senior manager gets everything that is sent up.)
In competing, the degree of expropriability of the technology is 0.75.
Whoever produces more − the entrepreneur or the competing manager −
wins the competition. In the horizontal hierarchy, with the specialisation
alternative, each manager produces one unit and keeps half. In the
competitive alternative, each manager produces 0.75, but the entrepreneur
produces one and wins. Consequently, the managers decide to specialise.
Since the managers do not work with each other, they cannot collude to
beat the entrepreneur. The entrepreneur uses the logic of ‘divide and rule’
to maintain control.
In the example of the vertical hierarchy in Figure 7.1, the outcomes are
different. Under the specialisation alternative, Pietro will give half of his one
unit of production to the entrepreneur. He will also get half of the half unit
of production sent up by Ram. His total benefit is therefore ½ + ¼ = ¾. In
the compete alternative, Pietro leaves the firm together with Ram. Together
they make ¾ each for a total production of 1½. They therefore compete
with the entrepreneur and win. Pietro will make ¾ himself and keep half of
the ¾ produced by Ram, for a total of 11
8. Ram will keep ½ + ¾ = 3
8 .
The incentive for managers to compete is greater in the vertical hierarchy
because superior managers – and not the watchmaker – command the
loyalty of subordinates.
Successful vertical integration is conditional on growing the firm in stages.
Let us take this a little further.

60
Assume that:
• expropriability is 0.49
• there is a cost of specialising of 1.01
• managers work only for two periods.
The watchmaker avoids competition by taking on Pietro in the first period
and Ram in the second period. Pietro specialises since his payoff is ½ + ¾
= 1¼ − 1.01 = .24. Ram specialises because he will gain Pietro’s place in
the second period. Conversely, horizontal organization may be achieved by
giving the managers the potential to participate in the rents of the critical
resource if they specialise. The lesson is that too much power to managers
will destabilise the entrepreneur’s position, while too little will give them
little interest in the well-being of the firm.
In this framework control is defined in terms of access, which provides
individuals with the opportunity to expropriate the entrepreneur’s resource.
It is not identified with legal rights of ownership. Access is equivalent to
the degree to which an actor has information, which is what is delivered
by accounting. Thus, in this perspective the role of financial accounting
and management accounting are intertwined. There are differentials
of information within the firm and outside of it. Further, in contrast to
the theory of the firm, which focuses on legal ownership as determining
the boundaries of the firm, the focus on expropriation entails that the
knowledge that one has into the core processes constituting the success of
the firm determines the firm boundaries. Accounting plays a similar role.
Here is another illustration. In 1994 Maurice Saatchi, Chairman of Saatchi
& Saatchi, an advertising agency, proposed a generous options package
for himself, despite underperformance of the stock. But his principals,
US fund managers who owned 30 per cent of the stock, voted down the
proposal at the shareholder’s meeting. Maurice Saatchi and several key
senior executives then left, forming rival M&C Saatchi. They also damaged
the original firm, Saatchi & Saatchi, by taking some key accounts with
them. Zingales remarked, ‘In hindsight, the mistake the US fund managers
made was to treat Saatchi & Saatchi as a traditional company with clear
boundaries defined by its assets’ (2000, p.1641). That is, they mistook
legal ownership and managerial control.
Agency theory Power
Authority No. Firm is just a ‘nexus of
contracts’
Yes. Managers occupy a position
that facilitates expropriation
Rationality The actor processes information.
Information asymmetries are core
Information asymmetry remains
core
Accounting Accounting is the means through
which owners of the firm monitor
their investment
Accounting is distributed
throughout the firm
Figure 7.2: Agency theory and managerial power theory compared
This shows us the limits of a simple agency theory perspective compared
to one that recognises managerial power. We show the differences in
Figure 7.2.
We can examine another aspect of agency theory with a simple three-actor
model incorporating the idea that the parties have limited (‘bounded’)
rather than complete rationality.

61
There are three actors in the firm: the entrepreneur, the customer and
the employee. Each actor has inducements to participate in the firm and
makes contributions to the firm, as in Figure 7.3 below.
Inducement Contribution
Entrepreneur Revenue Costs
Employee Wages Labour
Customer Good Purchase price
Worker
CustomerEntrepreneur
Figure 7.3: Agency theory in a simple three-actor model
Each actor will remain in the firm for as long as the satisfaction they
derive from the net balance of inducements over contributions is greater
than the satisfaction they could obtain if they withdrew.
All of the actors involved in the negotiation are active and, in particular,
the employee is motivated. This opens up the question of the goodwill and
social satisfaction provided by the employee, as it does the motivations of
the entrepreneur and customer.
Actors not only bargain in terms of increments of contribution and
inducement, but also in terms of all-or-none participation or non-
participation. The decisions made by these parties are boundedly
rational in that decision-makers have limited ability to recall and process
information and limited insight into their own decision processes and
future preferences. Actors satisfy their claims because they rely on habitual
rules to make heuristic judgements about the world. The need to rely on
ongoing patterns of interaction to make decisions, which entail that they
form organisations. Again, we can contrast this behaviouralist approach
with that of agency theory as in Figure 7.4 below.
Agency theory Behaviouralism
The firm
objectives
Maximisation of the value
of the firm
The viability of the firm
Rationality Full Bounded
Accounting
Role
Accounting contributes to
monitoring
Biases in behaviour entail that there
are systematic influences on the way in
which accounting is conducted
Figure 7.4: Agency theory and behaviouralism compared
7.4 The institutional environments of accounting
This approach is taken further in literature that pays attention to the
organisational and social contexts in which accounting (and finance)
operate (Burchell et al., 1980). The focus is on the legitimacy of
formalised structures. A technical activity becomes ‘institutionalised’ when
it acquires a taken-for-granted quality that entails it is perceived as being
correct. Accounting does not merely describe pre-existing economic reality,
but rather plays a constitutive or inventive role in the construction of
economic reality. ‘Accounting is a craft without an essence’ (Chapman et
al., 2009, p.2). Accounting and finance are seen as a set of practices that
evolve over time within a social context.

62
An example may be taken from Mackenzie’s (2006) study introduction
of option trading on the Chicago Board Options Exchange. The trading
of options had been hampered by the absence of an accepted mechanism
for options pricing. The Black & Scholes formula was developed, which
eventually provided a rigorous mathematical proof of the value of option
contracts. However, initially the prices of options did not closely match
the prices predicted by application of the formula. By contrast, it was only
after the majority adopted the formula that the prices converged on its
predictions. Mackenzie terms this ‘performativity’: adoption of economic
theory entails that actors act in accordance with the precepts of economic
models. Following the 1987 market crash, prices diverged again as ‘put’
options – akin to the purchase of insurance against a fall in an asset’s price
– became more expensive than the formulas predicted.
In the literature on ‘critical’ accounting we may distinguish three strands.
1. Political economic accounts: accounting is not a technically neutral
practice, but rather reflects sets of interests in conflict or competition.
2. Ethnographies of accounting: examining the role of accounting
practices in the lived experience of users of accounts.
3. Accounting and governing economic life: contributing to social theory
by examining the role played by accounting in the functioning of
society.
Activity 7.1
Find a business magazine (such as Business Week or The Economist). Identify at least one
story that describes an ‘agency’ problem.
Principal/
agent
Positional
power
Behaviouralism Institutionalism
Model of
agency
2 actors 3 actors 3 actors No model
Accounting Passive Passive Constructivist Constructivist
Information
key?
Yes Yes Yes No – focus on
standards
Evidentiary
base
Statistics Experiments/
statistics
Experiments Qualitative
Scope of
analysis
Organisation Organisation Organisation Environment
Figure 7.5: Various analytical perspectives on accounting compared
We summarise this chapter’s argument in Figure 7.5 above. Accounting,
probably the oldest of the management disciplines, can be seen from
a variety of perspectives. It is a technical ‘tool’ for monitoring and
performance measurement, but also a set of calculative devices which
constitute the fabric of the firm. Markets are, for economists, coordinated
by prices, but the hierarchies which constitute firms are coordinated by
accounting rules.

63
• describe four different perspectives on the firm with the purpose of
comparing their approach to accounting and finance
• discuss the principal–agent model
• explain the differences between economic and sociological models of
the firm.
Why have so many firms adopted a multi-divisional structure?

Notes
64

Chapter 8: Management accounting: costing
65
Chapter 8: Management accounting:
costing
• describe the distinction between direct and indirect costs
• discuss different costing mechanisms
• compare the different approaches to costing, with examples.
Willman, Theme 0.
Education, 1998) third edition [ISBN 9780130802200] Chapters 3 and 4.
Cooper, R. and B. Chew ‘Control tomorrow’s costs through today’s designs’,
Harvard Business Review January–February 1996).
Hiromoto, T. ‘Another hidden edge – Japanese management accounting’,
Harvard Business Review July–August 1988.
Johnson, H. and R. Kaplan Relevance lost: the rise and fall of management
accounting. (Boston, MA: Harvard Business School Press, 2001) [ISBN
9780875842547], Chapters 1 and 3.
Merchant, K. and M. Shields ‘When and why to measure costs less accurately to
improve decision making’, Accounting Horizons 7(2) 1993, pp.76–81.
8.1.4 Works cited
Labro, E. ‘Is a focus on collaborative product development warranted from a
cost commitment perspective?’, Supply Chain Management, 11(6), 2006,
pp.503–09.
Weetman, P. Financial and management accounting. (Harlow: Financial Times/
Prentice Hall, 2006) fourth edition [ISBN 9780273703693].
8.2 Purposes of cost accounting
Costing procedures assist in making decisions regarding:
• mix of products, services and customers offered
• enhancement of the productivity of operations
• development of competitive strategy, for example, inventories.
Additionally, cost accounting provides information for financial accounting
disclosures. A debate in costing revolves around the question of whether
each objective implies a different approach to assessing cost.
Let us begin with a set of definitions:
Variable costs: Costs that vary proportionately with the level of an
activity such as a production or sales activity.
Fixed costs: Costs that remain constant despite changes in the level of
an activity such as a production or sales activity.

66
Direct costs: Costs that are unambiguously linked to the production of a
particular output.
Indirect costs: The cost of capacity that provides services to more than
one product.
Examples are given in Figure 8.1 below.
Direct costs:
‘Costs that are
unambiguously linked
to the production of a
particular output.’
Indirect costs:
‘The cost of capacity that
provides services to more
than one product.’
Variable costs:
‘Costs that vary
proportionately with the
level of an activity such
as a production or sales
activity.’
Examples: Materials Example: Power costs for
running machines where
the power consumed by
each machine is unknown,
handling materials, cost of
setting up machines.
Fixed costs:
‘Costs that tend to remain
constant despite changes
in the level of an activity
such as a production or
sales activity.’
Examples: Machine or
labour that is dedicated
to the production of one
product.
Examples: Personnel
costs, communication
systems, depreciation on
buildings and equipment
and amortisation on
intangibles.
Figure 8.1: Absorption costing
(See Kaplan and Atkinson, 1998.)
8.3 Production and service departments
Production departments directly produce or distribute the firm’s output.
Examples include machining centres and assembly departments.
Service departments provide services to production departments. Examples
are utilities, maintenance, purchasing, scheduling, production control,
stockroom, materials handling, housekeeping, customer order handling
and information systems.
The allocation of indirect costs seeks to assign the costs that are associated
with service departments (‘overheads’) to particular resource utilisation
processes. Figure 8.2 presents this graphically. (See Kaplan and Atkinson,
1998, p.61.)
Figure 8.2: Two-stage absorption costing system
Service
departments
Service
department
expenses
Production
centre
expenses
Production
cost
centres
Direct machine hours Direct labour hours
Products

67
The cost control objectives in assigning service department costs are
manifold (see Kaplan & Atkinson, 1998). They:
• provide incentives for (1) the managers of service departments to
operate efficiently, and (2) managers of production departments to
efficiently utilise service department outputs
• ration demand from user departments: managers of production
departments incur costs for using a service department
• provide signals on service department efficiency by adding a charge to
the final product that reflects the cost of the service department
• facilitate comparison with externally sourced services, by assigning a
price to the service provided by the service department
• provide opportunities for price/quality trade-offs as managers have
information with which to negotiate with the service department.
We need to measure the costs of using service departments and this can be
done in one of two ways.
‘Attribution’ is the process of assigning a cost that is unambiguously
associated with a particular cost object to that particular cost object.
For example, the power department knows how much is used by
the manufacturing department by metering the power used by that
department.
‘Allocation’ is the process of assigning a resource cost to a department
or product when a direct measure does not exist for the quantity of the
resource consumed by the department or product.
In absorption costing the allocation of indirect costs to a department takes
place with reference to the proportion of a certain direct cost incurred by
that department. For example, ‘direct labour hours’ refers to the proportion
of total hours worked that are attributable to a particular department to
which the indirect cost is allocated.
Example 1:
The monthly cost for Service Department S is $1,000,000.
The total number of hours worked within the plant is 100,000.
Within Department D 50,000 total hours were incurred.
Therefore allocation of indirect costs to Department D
= $1,000,000 * 50,000 hours / 100,000 hours = $500,000
The selection of a particular driver to assign indirect cost to a product depends on the
nature of the activity.
Direct labour dollars ………………... Manual assembly
Direct labour hours
Machine hours ………………….…… Automatic machines
Units produced
Materials processed…………...... Continuous use of resource

68
Example 2: Tradition costing in a three-product firm.
Product A Product B Product C Total
Units sold 20,000 15,000 5,000
Direct material cost 2,500 2,300 2,000
Direct labour cost 1,400 2,100 700
Labour hours / unit 2 3 1 90,000
Machine hours / unit 1 2 5 75,000
Production batches 2 4 6 12
Sales orders 10 18 20 48
Purchase orders 20 15 25 60
Indirect costs 33,000,000
Depreciation 80,000,000
Materials & tools 17,000,000
Total: 135,000,000
Our task is to allocate the total indirect costs to the three products.
Product A Product B Product C
Indirect cost 3,000 4,500 1,500
Total 6,900 8,900 4,200
Product A: $135,000,000 indirect costs / 90,000 direct labour hours =
overhead rate of $1,500 / direct labour hour
$1,500 * 2 labour hours / unit = $3,000
Product B: = 135,000,000 / 90,000 * 3 = $4,500
Product C: = 135,000,000 / 90,000 * 1 = $1,500
There are a number of problems associated with the allocation of indirect
costs. For example, a meter measures the power consumed by a factory
from the power plant, but does not measure the usage of power by the
departments within the factory. One possibility is to allocate the usage
of power to the departments with reference to the horsepower of the
machines in the plant or the hours the machines have been operated
(machine hours). However, ‘machine hours’ is an imprecise method for
allocating indirect costs here, since machine hours in the production
department bear no causal relationship to the actual consumption of
resources in the service department.
To take another example: You take a trip to Bath for the dual purpose
of sightseeing and shopping. The train ride costs £20. How do you
allocate this cost between the two activities? You could use time spent on
sightseeing versus shopping. Suppose you spend 50 per cent of your time
sightseeing. You allocate £10 of overhead to the sightseeing activity.
However, there is no direct cause-and-effect relationship between the
method used to distinguish between the different elements of these
joint costs and the monetary allocation to sightseeing. Similarly, when
allocating head-office salaries between different products, the bases used
for this allocation bear no causal relationship to the actual consumption

69
of resources in the service department. There is, strictly speaking, no
relationship between the cost driver and the overhead costs that are
actually consumed by the production department.
Activity 8.1
Think about the production of this subject guide.What are the main direct and indirect
costs?
8.4 Activity-based costing
A second costing approach is activity-based costing (ABC: see Kaplan and
Atkinson, 1998). This is illustrated graphically in Figure 8.3. The first step
involves collecting data on specific activities. As Kaplan and Atkinson note,
‘One does not need extensive time and motion studies to link resource
spending to activities performed’ (1998, p.99). Data on activities is
gathered through:
• interviews
• surveys
• activity dictionaries.
The degree of acceptable approximation depends on cost and the objective
of the costing exercise. Greater precision is required for productivity
enhancements than for costing products, services and customers.
Figure 8.3: Activity-based costing
(See Kaplan and Atkinson, 1998, p.98.)
Activity-based costing links the resource expenses to activities performed
in the firm, establishing a direct causal link between expenses that, in
absorption costing systems, are treated as common and are allocated to
products. The hierarchy of unit, batch, product and customer-sustaining
activities captures the fact that different types of products consume
resources differently and in accordance with the complexity of the
product.
Unit-level activities represent work performed for every unit of product
or service produced. The quantity of resources used by unit-level activities
is proportional to the products’ production and sales volumes. Cost drivers
for unit-level activities include labour hours, machine hours and material
quantity processed. However, one of the advantages of activity-based
costing is that it recognises that support activities that are conducted with
respect to production are not only driven by unit-level activities.
Inspect
incoming
materials
Maintain
machines
Move
materials
Set up
machines
Prepare
tooling
Maintenance
hours
Setup
hours
No. of
setups
No. of
moves
No. of
receipts
$ /Maintenance
hour
$ / Setup
hour
$ /
setup
$ /
move
$ /
receipt
1) Resource
2) Activity
3) Product /
service /
customers
Resource
driver
Activity
Cost
Driver
Indirect labour

70
Batch-level activities include setting up a machine for a new
production run, purchasing materials and processing a customer order.
Resources required to perform a batch-level activity are independent of
the number of units in the batch (number of components produced after a
set-up, number of items in a purchase order or the number of products in
a customer shipment).
Product-sustaining activities represent work performed to enable the
production of individual products (or services) to occur.
Customer-sustaining activities represent work that enables the
company to sell to an individual customer, but which is independent of the
volume and mix of the products (and services) sold and delivered to the
customer.
We may also use activity-based costing on Example 2, of our three-product
firm. It emerges that the absorption and activity-based methods produce
markedly different cost outcomes per product.
Product firm example – ABC
Activity Activity driver Indirect wages Depreciation Materials
Assembly Machine hours 12,000,000 58,000,000 5,000,000
Reception Purchase orders 9,000,000 2,000,000 1,000,000
Set up No. of batches 6,000,000 15,000,000 3,000,000
Wrapping Sales orders 6,000,000 10,000,000 8,000,000
Total 33,000,000 85,000,000 17,000,000
Total indirect costs = 135,000,000
Example: calculating the reception cost of product A.
Total cost of reception activity =
12,000,000 (= 9,000,000 + 2,000,000 + 1,000,000)
The number of purchase orders, the activity cost driver = 60
The activity cost driver rate = 12,000,000 / 60 = 200,000
The indirect cost allocation to product A, which consumed 20 purchase orders = 20
*200,000 = 4,000,000
Reception cost / units of product A = 4,000,000 / 20,000 units = 200.
Assembly 1,000 2,000 5,000
Reception costs 200 200 1,000
Set-up costs 200 533 2,400
Wrapping 250 600 2,000
Total 5,550 7,733 13,100
Comparison of absorption and ABC product costs:
Absorption 6,900 8,900 4,200
ABC 5,550 7,733 13,100
% Difference -20% -13% + 212%

71
Figure 8.4 summarises the main difference between the two methods (see
Labro, 2006). The choice of a management accounting technique has a
major impact on the cost allocation outcome.
Figure 8.4: Absorption costing and activity-based costing compared
Activity 8.2
Examine the results of your last activity on the direct and indirect costs of this guide.
Apply activity-based costing to the production of this guide.What differences emerge?
This chapter introduced management accounting as a set of practices
relating to the internal control of the corporation and their evolving role
in facilitating decision making by managers. We focused on costing. We
distinguished between direct and indirect costs, and between standard
costing methods and activity-based costing.
• describe the distinction between direct and indirect costs
• discuss different costing mechanisms
• compare the different approaches to costing, with examples.
What would be the best costing method to adopt in a retailing business?
Absorption costing Activity-based costing
RESOURCES
COST POOLS
PRODUCTS
RESOURCE COST
POOLS
ACTIVITY COSTS
PRODUCTS /
CUSTOMERS /
SERVICES
Allocations
Machine hours
Direct labour hours
Resource cost
drivers
Activity cost drivers

Notes
72

Chapter 9: Management accounting: decentralisation and performance measurement
73
Chapter 9: Management accounting:
decentralisation and performance
measurement
• introduce themes in management accounting relating to the collecting,
processing and analysis of information regarding the internal
functioning of the firm
• describe the relationship between performance measurement and
decentralised forms of organisation
• apply the balanced scorecard.
Willman, Themes 4 and 5.
Education, 1998) third edition [ISBN 9780130802200] Chapter 8.
Christensen, J. and J. Demski Accounting theory: an information content
perspective. (Boston: McGraw-Hill/Irwin, 2002) [ISBN 9780072296914]
Chapter 10.
Ittner, C.D. Larcker, M. Meyer ‘Subjectivity and the weighting of performance
measures: evidence from a balanced scorecard’, The Accounting Review
78(3) 2003, pp.725–58.
Merchant, K. and W.A. van der Stede Management control systems. (Harlow:
Financial Times/Prentice Hall, 2007) [ISBN 9780273737612] Chapter 11,
pp.470−79.
Meyer, M. and V. Gupta ‘The performance paradox’, Research in Organizational
Behaviour 16 1993, pp.309–69, especially pp.325–53.
Meyer, M. Rethinking performance measurement: beyond the balanced
scorecard. (Cambridge; New York: Cambridge University Press, 2002)
[ISBN 9780521812436 (hbk)].
9.1.4 Works cited
Braverman, H. Labor and monopoly capital. (New York: Monthly Review Press,
1974) [ISBN 9780853453406].
Chandler, A. The visible hand: the managerial revolution in American business.
(Harvard: Harvard University Press, 1977).
Kaplan, R. ‘The evolution of management accounting’, The Accounting Review
LIX(3) 1984, pp.390–418.
Kogut, B. and D. Parkinson ‘Adoption of the multidivisional structure’, Industrial
and Corporate Change 7(2) 1998, pp.249–73.
Kaplan, R. and D. Norton The balanced scorecard. (Harvard: Harvard Business
School Press, 1996) [ISBN 9780875846514].

74
9.2 Introduction
According to Meyer (2002), the goals of performance measurement are as
follows.
1. Look back: an assessment of how the unit performed in the past.
2. Look ahead: past performance should provide information on future
return.
3. Compensate: performance measures should inform compensation.
4. Motivate: performance measures should motivate and direct action.
5. Roll up from the bottom to the top: performance measures of those in
the smallest organisational units within the firm should be linked to
the performance of the firm as a whole.
6. Cascade down from the top to the bottom: firm-level performance
measures should inform the work of those at the smallest
organisational units within the firm.
7. Compare: performance measurement should facilitate comparison
between units.
We need to bear these goals in mind when we consider the development of
performance measures within the large multidivisional firm.
9.3 History
Applying scientific management brought with it a concern to measure
costs. Already in the 19th century, textile firms and then railroads had
developed internal administrative controls to manage complex processes.
Railroads in particular had to record and summarise massive volumes of
(often small) transactions; in addition to financial statements, they also
developed the reporting of operating statistics such as cost of transport per
ton mile and operating ratios (normally income divided by sales) (Kaplan,
1984, p.392). As we showed in Chapter 2, the railroad legacy was
significant for the emerging mass production and distribution business in
the USA, and this was true also of accounting practices. A central problem
was the separation of operating or direct costs from fixed or overhead
costs. There was little concern for returns on capital invested (Chandler
1977, pp.269–79).
Scientific management advocates may be credited with two changes
of emphasis. The first was to start the practice of allocating overhead
costs, but not capital costs, to products or periods (Kaplan, 1984, p.394).
The second was concerned with labour and, as we have seen, had two
aspects of this: to develop standard labour and material costs per unit
of output, and to use these standards for devising piece rates and bonus
payments (Braverman, 1974). A key point here is the integration, at least
for production workers, of organisation-wide measures with individual
performance pay. There were many issues to deal with (see below) but
this − the link between individual and organisational performance − has
arguably been a ‘holy grail’ for performance measurement ever since.
As organisations became larger and more complicated, developing a set of
performance measures that could operate across the entire firm became
more problematic. Thanks to the work of Chandler (1977), developments
of considerable significance at DuPont and then subsequently General
Motors have been well documented. Faced with the problem of measuring
the outputs of functionally diverse departments such as purchasing,
manufacturing and sales, DuPont developed the measure of return on

75
investment (ROI), which could also be used as a measure of corporate
financial performance. Capital could thus be allocated to activities
generating the highest return. In this functionally organised business,
then, we have local profit measures evaluating departmental performance
in a way directly analogous to the ideas of cost-or profit centres used much
later (Kaplan, 1984, p.398).
In 1984, Kaplan felt that the development of management accounting
had rather stagnated, since the achievements of General Motors (by
1925) in adapting these ideas to the emerging divisionalised form. As we
shall see below, he was to do something about this, but it is worthwhile
summarising his account of the four key elements of the system.
1. The overall objective was to achieve an average satisfactory ROI across
a business cycle, not to achieve year on year increases.
2. There developed a pricing system to determine target prices that
would yield the desired ROI when production and sales were ‘normal’
(operationally defined as 80% of capacity).
3. An explicit senior manager incentive scheme, based on an explicit
profit formula, linked divisional and firm performance to individual
rewards.
4. A sophisticated market-based transfer pricing system priced
interdivisional transfer of product.
(Kaplan, 1984, pp.399–401.)
In order to understand these issues, let us compare measures in a unitary
versus divisionalised firm. The unitary structure is presented in Figure 9.1.
Figure 9.1: The unitary firm (late 19th to early 20th centuries)
Different functions within the firm have measures appropriate to
their activities, which are essentially difficult to compare. By contrast,
within the multidivisional firm of Figure 9.2, we are attempting unified
performance measures across diverse activities.
Gross sales less returnsCapacity utilisation,
down time, defects
Costs,
raw materials,
availability
Accounting
metric
Organisational
design
Purchasing Manufacturing Sales
Central office

76
Revenues of C
Earnings of C
Revenues of A
Earnings of A
Accounting
metric
Organisational
design
Unit A
Cars
Unit B
TVs
Unit C
Fridges
Central office
Revenues of B
Earnings of B
Purchasing Manufacturing Sales
Figure 9.2: The multidivisional firm
We have looked at revenues and earnings in Figure 9.2 as the key
measures. Let us look at how these might be applied.
9.4 Using return on investment (ROI)
Return on investment is a generic term capturing the idea that the returns
of the business can be measured with reference to the income generated
by the capital invested in the firm.
Return on investment (ROI) = income / invested capital.
As mentioned further in the chapter on financial ratios, the great
advantage of the ROI measure is that it can be decomposed into
components that reflect margins and efficiency.
Income / invested capital = (income / revenue) * (revenue / invested
capital) = return on sales (margins) * capital turnover (efficiency)
In fact a whole hierarchy of such measures can be created and, in each
case, a component of performance is identified and its contribution
assessed. Another advantage of return on investment is that it can be
compared to rates of interest, inflation or the performance of other
businesses. However, there are at least two drawbacks of using ROI.
1. It was initially associated with a management style that was engaged
with the operational details of the businesses concerned. In the
post-war period, diversification meant that central-office managers
were less familiar with the underlying business. ROI places a greater
strategic emphasis on financial measures than on operational ones.
2. Actions that increase ROI may decrease the long-run value of the
division and the firm and vice versa. For example, lowering investment
may yield short-term increases in returns, but long-term declines.
Here is an example.
Division A of a firm has assets of $100,000 and net income of 25,000.
ROI = 25,000 / 100,000 = 25%
Suppose Division A’s cost of capital is 15% and that a new investment
opportunity yielding 4,000 on an investment of 20,000 becomes available.

77
Despite the fact that the ROI of the new investment is 20% and is higher
than the cost of capital of 15%, the divisional manager will reject the new
opportunity because it reduces the division’s overall ROI.
= (100,000 + 20,000) / (25,000 + 4,000) = 24.2%
The idea of residual income becomes important here. It is defined as
follows.
Residual income = (income – cost of capital) * invested capital. In our
example:
Division A (before) Division A (after)
Invested capital 100,000 120,000
Net income before tax 20,000 24,000
Capital charge (@ 15%) 15,000 18,000
Residual income 5,000 6,000
The residual income calculation determines whether a project contributes
or destroys value. In this case, it is positive. This therefore reflects the
requirement of shareholders for both profits and growth and aligns the
interests of the divisional manager and the enterprise.
Residual income was introduced at companies such as General Electric and
Matsushita in the 1950s and 1930s, respectively, but was not otherwise
widely adopted. Why?
1. The shortcomings of ROI metrics only came to be the focus of investors
when there was greater discipline exercised by financial markets upon
firms, for example through the takeover boom of the 1980s. ROI in
our example makes divisional managers risk-averse and driven by the
performance measure rather than the increase in shareholder value.
2. The widespread adoption of financial techniques for estimating
the cost of capital only occurred following the development and
dissemination of financial economics in the mid-1960s. Particularly if
the capital for the new investment came from cash flows elsewhere
within the company, the cost of capital could be wildly inaccurate.
3. There was a mismatch between internal accounting practices and
practices for external financial reporting.
An extension of this line of reasoning finds expression in the concept of
economic value added (EVA). EVA is calculated as follows:
EVA = (adjusted after tax operating income – cost of capital) * invested
capital
EVA extends the residual income method by:
1. deriving the capital charge from methods developed in financial
economics (capital asset pricing model, CAPM, which we discuss in the
next session)
2. adjusting the reported accounting information in accordance with the
framework of financial economics; it adopts a fair value conception
of accounting − where necessary making adjustments to Financial
Accounting Standard standards.
For example: Expensing versus capitalising
Leasing
Price level adjustments
Depreciation

78
Both EVA and ABC (dealt with earlier) are complementary in that both
may be calculated at the level of product, activity or customer. EVA focuses
attention on areas where profitability is low. ABC may then be applied
to correct these at a level of granularity. Both are rooted in the attempt
to derive underlying economic processes in a manner that corrects for
imperfect financial accounting standards. Kaplan and Atkinson note:
The integration of ABC and EVA is natural. Both were developed
to solve a distortion in the financial reporting of company
economics. ABC corrected the arbitrary allocations of factory
overhead to products and the failure to assign other indirect
expenses to products and customers. EVA corrected the failure
of financial accounting statements to recognize the cost of
capital as an economic expense before arriving at a profitability
figure.
(Kaplan and Atkinson, 1998, p.523)
Activity 9.1
Go to the website of any large firm and find the latest financial statement, then calculate
the ROI.
9.5 The balanced scorecard
The balanced scorecard (see Kaplan and Atkinson, 1998, pp.367–80)
is one of the most widely used performance measurement tools. In
it, financial measures (addressing the shareholder requirements)
are combined with non-financial performance measures reflecting
the requirements of customers, suppliers and employees, processes,
technology and innovation.
It balances ‘short-term’ financial measures with ‘long-term’ perspectives
on innovation, business process design and customer and employee
relationships. Kaplan and Atkinson (1998) argue that assessments of
performance that focus exclusively on historical financial performance are
no longer adequate, and that we need to introduce a focus on innovation
and a forward-looking dimension.
The balanced scorecard thus combines four perspectives on performance:
1. financial perspective (shareholders)
2. customer perspective (customers)
3. internal business perspective (processes, technology and innovation)
4. learning and growth perspective (employees).
9.5.1 Customer value propositions
Product and service attributes relating to functionality, price and quality,
and the management of customer relationship, include delivery of the
product/service to the customer, delivery and response times.
9.5.2 Internal business perspective
There are steps in a ‘generic value chain’:
1. Innovation: The balanced scorecard focuses on the development of
long-term metrics associated with innovation. It incorporates metrics
relating to how well the firm identifies new markets and customers,
and develops new products and services, into the performance
measurement system. For example, there may be measures relating
to basic and applied research, such as percentage of sales from new
product/proprietary products, new product introduction versus

79
competitors/versus plan, and time to develop next generation
of products. There may also be measures relating to product
development, such as time to market of new product, percentage of
products meeting customer expectation at launch and the time that it
takes the product to break even.
2. Operations: focus placed on efficient, consistent and timely delivery
of products and services to customers. Focus on quality and cycle
time. Relevant measures here include, for example, yield (ratio of
good items produced to good items entering the process), the time
from a particular point in the production process to some point near
completion, waste/returns, customer waiting times and the accuracy
of the information provided to customers.
3. Post-sales service: warranty and repair activities, treatments of defects
and returns, and processing and administration of payments; the time
it takes to resolve a client’s complaint; the percentage of calls dealt
with to customers’ satisfaction. There can be a shift from examining
business processes within individual departments to an integrated
analysis of performance of processes within the enterprise.
9.5.3 Organisational learning and growth perspective
These relate to people, systems and organisational procedures.
These issues form the platform through which changes in internal
business processes can achieve the requisite business performance to
accommodate the requirements of shareholders and customers. There is
a focus on employee satisfaction as contributing to employee retention
and productivity. Information system capabilities can measure real-
time availability of information to relevant employees. Organisational
procedures can measure the alignment of employee incentives with overall
success factors.
9.5.4 Combining the perspectives
Balanced scorecards try to describe cause-and-effect relationships between
different aspects relating to the firm’s performance: ‘The measurement
system should make the relationships (hypotheses) among objectives
(and measures) in the various perspectives explicit so that they can be
managed and validated’ (Kaplan and Atkinson, 1998, p.376). A chain
of cause-and-effect relationships is established between performance
drivers and outcomes to provide an overview of how the overall strategic
performance of the firm is generated. It seeks to meet the previously
identified shareholder requirement for financial return and requirements
of targeted customers for price, timeliness and quality while maintaining
satisfied employees. This focus is achieved by adopting a perspective that
incorporates the requirements of all the major participants in the firm.
The balanced scorecard and EVA are complementary. Economic value
added metrics may be adopted as the financial metrics within the balanced
scorecard. These entail that investment decisions are consistent with
maximising the net present value of shareholders’ wealth. Both EVA
and balanced scorecard seek to address short-termism in performance
measurement. Employed as a remuneration tool, EVA is a means for
incentivising employees to act in ways that support shareholder value.
EVA and the balanced scorecard integrate strategy at all levels of the firm.
Both involve centralised decision-making. When performance measures
include both financial and non-financial factors, managers must perform in
certain dimensions as specified by top managers through the performance
measures selected.

80
9.6 Financial (ROI) versus balanced scorecard
performance measure
Financial (ROI) versus balanced scorecard performance measure
Financial (ROI) Balanced scorecard
Constituents Shareholders primarily Shareholders, customers and employees
Discretion Easy to manipulate Less subject to discretion
Perspective Historical Forward-looking
Scope Decentralised Integrative
Business era Industrial age Information age
Table 9.1: Critique of the balanced scorecard: institutionalist perspective
(See Meyer and Gupta, 1993.)
The institutional (sociological) approach begins by examining puzzles
regarding performance measurement. A key question is: why is it
common to observe an organisation employing many different types of
performance measure at the same time? Another is: why does the number
of performance measures used by firms increase over time?
The question to be examined is… whether rational people in
rational organizations would prefer seemingly non-rational
performance measures.
Might the type of disorderliness observed in virtually all
organizations and in their performance measures… contribute
to rather than detract from coordination and control, motivation
and incentive alignment and hence to positive outcomes?
(Meyer and Gupta, 1993, p.317.)
A key function of performance measurement is to reflect variability in
performance and to discriminate between good and bad performers. As a
performance measure is used, it is less able to discriminate the best from
the worst because their performances converge.
There are four reasons for this ‘running down’ of performance measures:
1. positive learning results in performance improvement
2. perverse learning is reflected in appearance but not the fact of
improvement
3. high performers are selected and low performers excluded
4. measures exposing persistent differences in performance outcomes are
suppressed.
This is the ‘use it and lose it’ principle in performance measurement.
If the performance measure that has run down is replaced with a measure
that defines performance in the same way, the new measure would, like
the old one, be unable to pick up variability. Necessarily, new performance
measures are uncorrelated with existing measures and pick up new types
of performance, and the evolution of performance measures entails that
different aspects of a firm’s performance are assessed over time.
Consequently, coordination and control is best achieved through multiple,
uncorrelated and changing performance measures that render it difficult
to know exactly what performance is (Meyer and Gupta, 1993, p.311).
The balanced scorecard argues that by combining performance measures
underneath a common bottom line, one achieves control. In contrast, the

81
performance paradox argues that control is achieved only by abandoning
the attempt to combine uncorrelated measures in such a way.
The chapter introduced themes in management accounting relating
to the collecting, processing and analysis of information regarding the
internal functioning of the firm. We investigated the relationship between
performance measurement and decentralised forms of organisation.
Following a review of different aspects of management accounting, we
covered issues concerning agency and institutionalist perspectives on
performance measurement. We outlined and discussed the balanced
scorecard.
• introduce themes in management accounting relating to the collecting,
processing and analysis of information regarding the internal
functioning of the firm
• describe the relationship between performance measurement and
decentralised forms of organisation
• apply the balanced scorecard.
1. What is a ‘balanced scorecard’? Why has the idea of a balanced
scorecard become so influential?
2. What are the strengths and weaknesses of return on investment
measures of divisional performance? How successful are other
measures of financial performance in addressing these weaknesses?
3. How does the balanced scorecard seek to further enhance performance
measurement through non-financial measures of performance?

Notes
82

Chapter 10: Financial accounting
83
• discuss the three elements of the financial report, namely, the balance
sheet, the profit and loss statement and the cash flow statement
• interrogate the qualitative requirements of financial accounting for
relevance, reliability, comparability and understandability.
Willman, Chapter 8.
sixth edition [ISBN 9780273789253] Chapter 7.
Atrill, P. and E. McLaney Financial accounting for decision makers. (Harlow:
Financial Times Prentice Hall, 2013) [ISBN 9780273785637], Chapters 2
and 3.
Higson, C. ‘Financial statements: Economic analysis and interpretation’ (2006).
sixth edition [ISBN 9780273789253] especially Chapters 8–12.
10.2 Management accounting and financial accounting
The distinction between management accounts and financial accounts is
long standing. Management accounting tools tend to be used for specific
managerial purposes and can be varied (though not in an unlimited way)
by managers pursuing particular objectives: for example, they may choose
a particular costing method or resource allocation tool; they may collect
information weekly, monthly or less often. In addition, management
accounts may collect information which is non-financial (e.g. on specific
activities), though often this information is collected because it is seen to
predict future cash flows.
Financial accounts, by contrast, are there in part to control managerial
agency and have predominantly (but not exclusively) an external
audience. They must contain certain elements and be set out in a
particular way to attain standards. Table 10.1 attempts to summarise the
differences between management and financial accounting.
Management accounting Financial accounting
Nature of reports Specific purpose General purpose
Level of detail Disaggregated Aggregated
Regulations Unregulated Regulated
Reporting interval As required Mostly annual
Time orientation Past and future Mostly past period
Information Financials and non-financials Mostly quantifiable in
monetary terms
Table 10.1: Management accounting and financial accounting compared

84
Financial accounts have a number of discrete users, not all of whom have
the same information interests. They include:
• owners and investors
• employees
• lenders
• suppliers and other trade creditors
• customers
• governments and their agencies
• public interest.
Some of these users do not share the same concerns; for example,
investors and tax authorities have very different interests in the financial
performance of a given company.
Financial accounts must comply with certain broad requirements for
relevance, reliability, comparability and understandability. These may be
elaborated as follows.
• Relevance relates to information that has the ability to influence
decisions. Information quality in financial reports may have
confirmatory value (relating to past events) or predictive value (future
ones).
• Reliability relates to the requirement that the information in reports
be a faithful and complete representation. It should in addition
be presented in a neutral way, be free from error and be based on
prudential assumptions.
• Comparability relates to the principles that similarities and differences
between companies or over time should be discernible and capable
of evaluation. It relates to the consistency of the data and the level of
disclosure.
• Understandability has two distinct components, but the underlying
principle is that the significance of information can be perceived.
The first component relates to users: information must be presented
in a way users can understand. The second relates to the level of
aggregation of the data and the categories of classification.
10.3 The elements of the financial report
We focus here on the three key components:
1. The balance sheet is concerned with the financial position at a
particular moment in time. What is the accumulated wealth of the
business at the end of each period, and what form does the wealth
take?
2. The income statement (US, IFRS)/profit and loss account (UK).
How much wealth was generated (or lost) by the business over that
period?
3. The cash flow statement. What cash movements took place over a
particular period?
Activity 10.1
Go to the website of a large firm of your choice and find the financial report.Answer
questions 1–3 above.

85
10.3.1 The balance sheet
The balance sheet is an assessment of a stock of wealth. The income
statement and cash flow statement are both concerned with measuring
flows (of wealth and cash respectively) during a particular time period.
Let us look at each in turn.
Cash
Trade receivables
Inventory
Property, plant and equipment
Intangibles (e.g. brands)
Financial assets and investments
Other assets
TOTAL ASSETS
Debt
Trade payables
Provisions
Other liabilities
Equity shareholder’s funds
Non-equity shareholder’s funds
TOTAL LIABILITIES and SHAREHOLDERS’ FUNDS
}
}
List of the firm’s assets
List of the claims on the firm’s
assets by third parties and the
shareholders
Total Assets = Total Liabilities + Shareholders’ Funds
OR
Assets – Liabilities = Shareholders’ Equity
Figure 10.1: The elements of the balance sheet
As we will see, some assets are easy to value (cash) and others (value
of the brand) may be more contentious. The same is true of liabilities.
Debt is often clear, but provisions against, for example, a lawsuit, may be
contentious. It is important to define assets and liabilities.
Assets are defined by the professional body, the Financial Reporting
Council, as: ‘Rights or other access to future economic benefits controlled
by an entity as a result of past transactions or events.’
‘Rights or other access’ may mean outright ownership, or a lease or rental
agreement.
‘Future economic benefits’ may be cash flows or other benefits.
‘Controlled by an entity’ implies not only access but restrictions on the
assets of others.
‘Past transactions or events’ means that there must be evidence that the
entity has gained control of the resource.
Liabilities are defined as ‘obligations to transfer economic benefits as a
result of past transactions or events’.
‘Obligations’ refer to another legal entity that has legal claim to payment.
For example, trade creditors who have supplied goods in expectation of
future payment, or lenders who expect to be repaid.
‘Transfer economic benefits’ could be in the form of cash, property or
(unusually) labour.

86
‘Past transactions or events’: a transaction generates a liability, a warranty
implies an uncertain date at which the liability is incurred.
An aside: price to book ratio
The price to book ratio highlights the relationship between a firm’s current
stock market capitalisation and book equity, the capital provided by equity
shareholders to the firm.
Price to book ratio = Market capitalisation/Equity
shareholders’ funds
Market capitalisation = Share price * No. of shares in issue
An entity level measure of the price to book ratio is Enterprise price to
book.
Enterprise price to book = Enterprise value/Capital employed
The difference between the accounting measure and the market value
is indicative of the value created by the firm. In Table 10.2 we show the
book and market value of Tiffany, the luxury good firm. Tiffany has in
this period a substantially greater market capitalisation than book value
and so, even though the market value of its debt has risen slightly, it has
substantially lower gearing on the market than the book measure.
2003 2004 2005
Shareholders’ funds 1,208.0 1,468.2 1,701.2
Debt (current & long term) 349.7 486.9 440.6
Minus cash 156.2 276.1 326.9
Net debt 193.5 210.7 113.7
Capital employed 1,401.5 1,678.9 1,814.8
Book gearing 13.8% 12.6% 6.3%
Table 10.2.1: Tiffany market gearing
2003 2004 2005
Market capitalisation 3,368.1 5,816.6 4,543.1
Market value of debt 371.0 520.8 472.0
Minus cash 156.2 276.1 326.9
Net debt 214.8 244.7 145.1
Enterprise value 3,582.9 6,061.3 4,688.3
Market gearing 6.0% 4.0% 3.1%
Table 10.2: Tiffany book gearing

87
10.3.2 The income statement
Sales
− Cost of sales
= Gross profit
− Sales, general & administrative expenses
= Operating profit
+ Other income
− Exceptional items
= Earnings before interest & tax
− Interest
= Earnings before tax
− Tax
= Earnings after tax
− Minorities
}
}
How the firm earned
its income.
How the income is shared
amongst those with a claim
on the firm.
− Preference dividends
= Earnings
Figure 10.2: The elements of the income statement
The income statement is a measure of wealth flow over the accounting
period. It answers the question of how much wealth was generated (or
lost) over that period. It shows both how the firm generated income and
how the income is shared with those with a claim on the firm.
The profitability of the company is the degree of success in creating wealth
for owners. Return on equity measures the performance of the firm from
the perspective of its shareholders. Return on equity is calculated as
follows:
Return on equity = Earnings/Average shareholders’ funds
Return on capital employed measures the return on the capital of the
whole business. It is an ‘entity’ return on capital that measures the
profitability of the firm’s assets, independent of financing.
Return on capital employed = EBIT/Average capital employed
So we need also a measure of capital employed, which is calculated as
follows:
Shareholders’ Funds + Current and long-term debt – Cash =
Net debt = Capital employed
Capital employed is equivalent to the net operating assets of a business.
Profit margins are calculated as follows:
Gross profit margin = Gross profit/Total sales revenue
Mark up = Gross profit/Cost of goods sold
Gross profit = Sales revenue – Cost of sales
Net profit margin = Operating profit/Total sales revenue
Sales margin = Net profit/Total sales revenue

88
10.3.3 The cash flow statement
Profit differs from the cash received by the firm. The cash flow statement
is concerned with measuring the flow of cash during the recording period.
The calculation is:
Cash flow = Cash inflow – Cash outflow
Cash will flow following:
• operating activities such as making and selling products
• investing activity such as trading assets
• financing activities such as raising (or repaying) equity or debt.
The main elements of the cash flow statement are shown in figure 10.3:
Earnings before interest and tax
Non-cash charges
Earnings before interest, taxation, depreciation and amortisation
Tax on EBIT
Investment in working capital
Cash from operations
Investment in long-term assets (capex)
Operating free cash flow
Interest and dividends
Tax shelter on interest
Cash flow before financing
Equity financing
Debt financing
Change in cash and financial assets
Cash flow = income – change in the balance sheet
Figure 10.3: The elements of the cash flow statement
Activity 10.2
For the same firm as the last activity, calculate the cash flow.
There are processes for distinguishing cash from profit. Examples follow.
• Repayment of a loan:
effect on profit: none; effect on cash: decrease.
• Making a sale on credit:
effect on profit: increase; effect on cash: none.
• Buying a current asset on credit:
effect on profit: none; effect on cash: none.
• Receiving cash from a credit customer (trade receivable):
effect on profit: none; effect on cash: increase.
• Depreciating a non-current asset:
effect on profit: decrease; effect on cash: none.
• Buying some inventories for cash:
effect on profit: none; effect on cash: decrease.
• Making a share issue for cash:
effect on profit: none; effect on cash: increase.

89
We will pursue some of these issues further with a worked example.
Example: A match seller
A match seller has $4 in his pocket on Monday morning. He goes to the
wholesaler and buys 100 boxes of matches for 4 cents each. During the
day he sells the 100 boxes for 10 cents each. How do we calculate the
profit?
(10 cents revenue per box – 4 cents cost per box) * 100 boxes = $6
profit
Alternatively:
Assets at the beginning of the period = $4 cash
Assets at the end of the period = $10 cash
Profit = Change in the value of net assets over the financial period:
$10 – $4 = $6
The income statement, providing an indication of the financial
performance of the firm, reflects the change in the values disclosed in the
balance sheet over the relevant periods. In the second week the match
seller buys all the matches he will need during the week (500 boxes) on
Monday morning. He sells 100 boxes on Monday.
How do we now calculate his profit?
Monday morning’s assets = 500 (boxes) * 4 cents = $20
Monday night’s assets = 400 (boxes) * 4 cents = $16
plus cash = 100 boxes * 10 cents = $10
Total assets = $16 + $10 = $26
Profit = $26 − $20 = $6.
In this example we value the match seller’s remaining 400 boxes (his
assets) at cost price.
An alternative is to value these assets at the expected market price. In this
case the profit is calculated as follows:
Assets on Monday morning = $20 (500 boxes * 4 cents)
Assets on Monday night = $50 (400 * 10 cents + $10 cash)
Profit = $30
These are different account models, but the conventional and accepted
accounting model does not value the assets at market price because of the
principles of recognition and matching.
10.4 Recognition and matching
Revenue (and profit and loss from a transaction) is not recognised until it
is earned. Revenue is ‘realised’ when a legally enforceable sale has taken
place – that is, when an asset has been created in the form of cash or a
claim on the customer.
Matching of expenses and revenues: an expenditure is the payment of cash
for the purchase, for example, of a machine. An expense is the recognition
of that part of the expenditure which has been used in generating the
revenue.
Depreciation of an asset is the expense deriving from consumption of a
tangible asset that derives from the use of that asset for the purpose of
generating the revenue for that period.

90
Financial assets are treated slightly differently. Financial assets are 1) cash,
2) assets that will be settled in cash or in the form of another financial
asset, and 3) shares in another firm. They are typically valued in the same
way as non-financial assets, with two exceptions, where they are valued at
market price.
4. ‘Held for trading’ financial assets are regarded as intending to profit
from short-term market fluctuations. These are valued at current
market price ‘fair value’ and revaluation of these assets impacts on the
determination of income.
5. ‘Available for sale’ financial assets are regarded as held on an
intermediate time frame and are valued at market price. Revaluation
is not recognised in the income statement, but rather in a broader
statement of the performance of the reporting entity.
• The income of a business during a period is the increase in its assets
adjusted for any withdrawals by the owners.
• A firm’s balance sheet is a list of its assets and the claims against those
assets.
• There are two types of claim. Liabilities are amounts owed to third
parties. Shareholders’ funds are the residual claim on the firm,
the difference between its assets and liabilities and measure the
shareholders’ wealth in balance sheet terms.
• The change in the shareholder’s wealth over a period, adjusted for
capital flows, measures the firm’s profit.
• discuss the three elements of the financial report, namely, the balance
sheet, the profit and loss statement and the cash flow statement
• interrogate the qualitative requirements of financial accounting for
relevance, reliability, comparability and understandability.
What are the key elements of a cash flow statement and how should they
be interpreted?

Chapter 11: Modern portfolio theory
91
• introduce the financial framework relating to risk and reward
• describe asset allocation and long-term rates of return of different
asset classes
• discuss the relative returns of asset class selection and security
selection.
Willman, Chapter 8.
D. Hillier, M. Grinblatt and S. Titman Financial markets and corporate
strategy. (Maidenhead: McGraw-Hill Higher Education, 2011)
[ISBN 9780077129422], Chapter 4.
Dimson, E. and P. Marsh Triumph of the optimists: 101 years of global investment
returns. (Princeton, NJ; Oxford: Princeton University Press, 2002)
[ISBN 9780691091945].
Swensen, D. Pioneering portfolio management: an unconventional
approach to institutional investment. (New York: Free Press, 2009)
[ISBN 9781416554035].
Williams, A. Managing your investment manager: a complete guide to
selection, measurement and control. (Homewood: Dow Jones Irwin, 1986)
[ISBN 9780870947230].
11.1.4 Works cited
Fama, E.F. ‘Efficient capital markets: a review of theory and empirical work’,
Journal of Finance, 25(2), 1970, pp.383–428.
Fama, E.F. ‘Efficient capital markets II’, Journal of Finance, 46(5), 1991,
pp.1575–1617.
11.2 Interest rates and the time value of money
For most financial decisions, costs and benefits occur at different points
in time. Consider an investment opportunity that costs $100,000 today
and pays $105,000 in one year. Is the net value of the project $105,000–
$100,000?
No. In comparing these two payments we need to take account of the time
value of money: the difference between money today and in the future.
Suppose the one-year interest rate with the bank is seven per cent. This
investment alternative enables us to have $107,000 in one year, which is
superior to the project. In one year $107,000–$105,000 = $2,000.
What is the value of difference between these two projects today?
If the interest rate is seven per cent, then what amount would we need to
invest today to have $105,000 in one year?
= X * 1.07 = $105,000

92
X = $105,000/(1.07) = $98,130.84
The difference between the two investment opportunities is therefore
worth $100,000–$98,130.84 = $1,869.16 today.
The present value of $105,000 received in two years’ time is: $105,000/
(1.07*1.07) = 1.14
More generally, the present value of a future cash flow = C/(1+r)?, where
C= cash flow
r = interest rate
n = number of years.
11.3 The return of a single security
The return of a security is composed of two elements:
1. the income that the security pays as dividends or interest
2. capital gains, comprising the change in the security’s price over a
period.
Total return = (End price – Start price + Income)/Start price
For example: a stock pays a dividend of $1 and the share price increases
from $10 to $11. The total return = $1 + $11 − $10 = $2. This is a
percentage return of $2/$10 = 20%. We are assuming that the income
was paid at the end of the period.
11.4 The return of a portfolio
The expected return is the average return we would expect to earn if we
repeated the investment many times with the return drawn from the same
distribution each time.
The outcomes differ each year with given probabilities of occurrence.
Current stock price Stock price in 1 year Return (R) Probability (Pr)
100 140 40% 25%
100 110 10% 50%
100 80 –20% 25%
Expected return = E(R) = Sum (Probabilities * Returns)
= 25% * 0.4 + 50% * 0.1 + 25% * −0.2 = 10%
11.5 Probabilistic considerations
When an investment is risky it may have different outcomes in terms of
return. For example:
Current stock price Stock price in 1 year Return (R) Probability (Pr)
100 140 40% 25%
100 110 10% 50%
100 80 –20% 25%
Expected (mean) return = E(R) = Sum (Pr * R)
= 25% * 0.4 + 50% * 0.1 + 25% * − 0.2 = 10%
A definition of the risk of a particular security is the degree to which the
price of the security fluctuates.

93
Which is riskier: the securities of company A or of company B?
Price
Time
B
A
Figure 11.1: The risk of a single security
We use variance and standard deviation as measures of risk. The
variability of different investments can be used as a measure of the risk of
that particular investment.
The variance examines the distribution of returns around a mean return
that is achieved over a period. The standard deviation is the square root of
the variance, as follows:
Var (R) = 1/(T–1) * Sum (Rt – E(R))
S.D. (R) = √Var (R)
11.6 Asset classes
An asset class is a set of investments that have a broadly comparable
relationship to economic returns and liquidity. Broadly speaking,
traditional asset classes reflect the different payments that are made
to the owners of the firm and the lenders of money to the firm. More
recently, new types of investment opportunity have come to be accepted
as alternatives to these traditional investment opportunities. These include
hedge funds and private equity. This is despite the fact that private equity
may be said to be an ancient form of investment, predating public equities.
Investment Return Return volatility (standard deviation)
Treasury bills 3.7% 0.9%
Fixed income 5.8% 7.0%
S&P 500 9.6% 21.4%
Small stocks 18.2% 42.8%*
Real assets 6.3% 13.4%*
Hedge aunds 8.7% 8.6%
Private equity 17.6% 16.1%
* Real assets: 55% Real estate investment trusts, 35% Commodities and 10% Inflation-
linked treasuries.
Table: 11.1 Asset class risk and return: traditional assets (1926–2008)
Activity 11.1
Go to the BBC or Bloomberg website. Discover the returns and volatility of the six asset
classes above. Since 2008, which would be the best portfolio?
The table above indicates the return to different asset classes over a long period in the
last 100 years. Over this long time period, there is a clear, positive relationship between
risk (volatility) and return.This relationship is more generally reproduced.

94
11.7 What is a hedge fund?
The boundary between hedge funds and other investment vehicles is
not absolute, but is defined partly by legal structure: collective vehicles,
limited partnerships, private limited companies, etc.
Hedge funds are often based offshore and are largely unregulated. They
usually have an absolute return target and charge fees typically as a
percentage of the assets invested plus a proportion of any outperformance
of a hurdle rate. Hedge fund managers often invest significantly in the
fund. Typically, and crucially, they can leverage and short-sell stocks.
11.8 What is private equity?
The term ‘private equity’ refers to investment in private companies that
are not listed on any stock exchange. Often these are start-up, small
enterprises but they are not necessarily small companies, nor necessarily
new. For example, private equity firms may buy low-performing businesses
with the intention of installing a new management team, improving
performance and selling them at a profit.
The private equity market is not a single market. It includes:
• venture capital: early stage/start-up and later-stage financing
• development capital/expansion financing
• buyouts: small, medium and large management buyouts
• mezzanine finance
• restructuring existing capital.
11.9 Market efficiency
This account of the systematic risk of a particular security is dependent
on the notion that arbitrage entails that investors are not compensated
for idiosyncratic risk. If there was an opportunity to be so compensated,
then new traders would enter the market and, borrowing at the risk-free
rate, invest in a diversified portfolio of shares, increasing their price to
such a point that this was no longer a realisable investment opportunity.
This assumption is that the market is efficient in processing information
relating to investment opportunities. Further, the Beta is determined with
respect to a portfolio of securities that resembles the entire market, which
is efficient. The hypothesis that financial markets are efficient takes three
forms: strong form, semi-strong and weak (Fama, 1970, 1991).
11.9.1 Weak market efficiency
It is not possible to use historical stock price information to produce alpha.
This means that technical analysis (trading based solely on historical price
patterns) would not earn abnormal returns. The weak form assumes that
all information contained in past prices of a stock are reflected in today’s
price.
11.9.2 Semi-strong market efficiency
It is not possible to use any publicly available information to produce
alpha. This means that fundamental trading (trading based on underlying
firm information) would not earn abnormal returns. The semi-strong form
assumes that all public information is reflected in today’s stock price.

95
11.9.3 Strong market efficiency
Market prices incorporate even the most private information held by
the deepest insiders in corporations. This means that no trading would
produce alpha. The strong form assumes that all information, both public
and private, is reflected in today’s stock price, so that nothing – not even
insider information – can be used to beat the market.
11.10 Optimal portfolio choice
The diversification benefits of having different assets in a portfolio derives
from the fact that asset prices move differently.
Covariance is the expected product of the deviation of two returns from
their means.
Cov (Ri, Rj) = E[(Ri – E(Ri)) * (Rj − E(Rj)]
Correlation controls for the differing volatilities of the stocks.
Corr (Ri, Rj) = Cov (Ri, Rj)/(SD (Ri) * SD (Rj))
The correlation is between −1 and + 1, providing an indication of the
strength of the relationship between the two assets.
Asset
class
Equities Fixed
income
Cash Hedge
funds
Private
equity
Real
assets
Equities 1
Fixed
income
0.25 1
Cash 0.02 0.03 1
Hedge
funds
0.38 0.14 0.22 1
Private
equity
0.41 –0.24 0.07 0.22 1
Real
assets
0.47 0.27 –0.06 0.45 0.36 1
Table 11.2: Asset class correlations (January 1970–December 2008)
The table shows correlations between different asset classes in the 40
years before the financial crash. It illustrates the data we might use to
construct an efficient portfolio.
11.10.1 The variance of a two-stock portfolio
Var (Rp) = X1 * Var (R1) + X2 * Var (R2) + 2 * X1 * X2 * Cov (R1,R2)
SD (Rp) = √Var (Rp)
The greater the covariation or the correlation of the two stocks, the higher
the volatility and the risk of the portfolio.
11.10.2 The variance of a portfolio
The variance of a portfolio is equal to the sum of the covariances of the
returns of all pairs of stocks in the portfolio, multiplied by each of their

96
portfolio weights. The overall variability of the portfolio depends on the
total co-movement of the stocks within it.
Here is an example of an efficient portfolio with two asset classes.
Take a portfolio that is invested only in bonds and private equity. The risk
and return characteristics of each asset class are as follows:
Asset class Return Volatility
Fixed income 5.8% 7.0%
Private equity 17.6% 16.1%
The correlation between the two asset classes is −0.24%.
Bond allocation Private equity
allocation
Portfolio return Portfolio
volatility
100% 0% 5.8% 7.0%
80% 20% 8.2% 5.8%
60% 40% 10.5% 6.8%
40% 60% 12.9% 9.4%
20% 80% 15.2% 12.6%
0% 100% 17.6% 16.1%
Activity 11.2
Now reconsider the data from your last activity. Does your view of what would be the
optimal asset portfolio change?
A portfolio is inefficient as long as it is possible to find another portfolio
that is better both in terms of return and expected volatility.
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
0.0%
2.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
Volatility
Inefficient
portfolios
Efficient portfolios
Return
Efficient
portfolios
4.0%
Figure 11.2: Efficient frontier (private equity versus bonds)
To the degree that the constituent investments are less correlated the
scope for gains arising from diversification is increased.

97
11.11 The Sharpe ratio
The Sharpe ratio measures the relationship between return and volatility.
Sharpe ratio = Portfolio excess return/Portfolio volatility.
Portfolio 2 has a higher Sharpe ratio than Portfolio 1. The tangent portfolio
provides a higher return per unit of volatility than any other portfolio.
Volatility
Return
Risk-free return
(T -Bills)
Inefficient portfolio
Tangent or efficient portfolio.
Conservative investors
combine the efficient
portfolio with the
risk-free asset.
Aggressive investors
borrow to invest
more in the efficient
portfolio.
Figure 11.3: Efficient and inefficient portfolios
In this chapter we have discussed:
• definitions of return and risk
• the risk and return characteristics of different asset classes
• the difference between systematic and idiosyncratic risk and the
concept of Beta
• the role of correlation in portfolio diversification
• the construction of an optimal portfolio.
• introduce the financial framework relating to risk and reward
• describe asset allocation and long-term rates of return of different
asset classes
• discuss the relative returns of asset class selection and security
selection.
What is an efficient portfolio?

Notes
98

Chapter 12: Security analysis and valuation
99
Chapter 12: Security analysis and
valuation
• describe the meaning of different financial ratios
• explain their application in conducting financial analysis of firms.
Atrill, P. and E. McLaney Financial accounting for decision makers. (Harlow:
Financial Times Prentice Hall, 2013) [ISBN 9780273785637], Chapter 8.
Willman, Theme 7.
Graham, B. and D. Dodd Security analysis. (New York: McGraw-Hill, 1934).
sixth edition [ISBN 9780273789253].
12.2 Financial ratios
Financial ratios are so-called because they develop a profile of a business’
financial health by relating two figures in the financial statements.
There are six different types of ratio:
• investment
• profitability
• margins
• efficiency
• financial leverage
• solvency and liquidity.
In this chapter we calculate some of the financial ratios of British Airways
in 2007/08.
12.3 Investment ratios
Investors in a company wish to know how well their investment has
performed.
Earnings per share = Profit after tax for ordinary
shareholders/No. of ordinary shares in issue
This ratio is frequently reported in the media as the headline figure
comparing the quarterly and annual performance of firms. The comparison
is made from one period to the next to assess the trend.
British Airways’ earnings per share (‘EPS’):

100
2008 2007
Profit £680,000,000 £290,000,000
Shares outstanding 1,158,630,000 1,151,943,000
Earnings per share £0.586 £0.252
Price/Earnings ratio = Stock price/Earnings per share
This is often called the ‘P/E’ ratio. It may be interpreted as the number of
years it would take for the current level of earnings to cover the current
price of the share. It is important to compare the P/E ratio of the share to
that of other companies in the sector or that of a suitable index to get an
indication of relative value.
Activity 12.1
What is the current P/E of BA?
Dividend yield = Dividend per share/Market price per share
In contrast with EPS and P/E ratio, which do not measure the actual
cash received by investors, dividend yield does deal with the cash that
investors receive. It is a measure of the income that the share pays to the
investor. Another potential source of earnings from investing in equities is
appreciation of the shares.
Price to book ratio = Market capitalisation/Equity
shareholders’ funds
Financial ratios are most useful when compared to a benchmark of some
kind:
• past periods for the same business
• similar businesses for the same or past periods (in the same sector)
• target performance for the business before the start of the current
period.
There can be various definitions of the ratios found in literature
and practice. It is important to use a consistent definition across the
benchmarks.
Market capitalisation = Share price * No. of shares in issue
The price to book ratio measures the degree to which the current market
price for the shares understates their true value.
An entity level measure of the price to book ratio is Enterprise price to
book.
Enterprise price to book = Enterprise value/Capital Employed
The difference between the accounting measure and the market value is
indication of the value created by the firm.
12.4 Profitability ratios
The profitability of the company tells us the degree of its success in
creating wealth for owners. It is important to understand the different
ratios that refer to it.
Return on capital employed measures the return on the capital of the
whole business. It is an ‘entity’ return on capital that measures the
profitability of the firm’s assets, independent of how these assets have
been financed.

101
Return on capital employed = Earnings before interest and
tax/Capital employed
The calculation of capital employed is as follows:
Shareholders’ funds + Net debt = Capital employed
Where:
Net Debt = Current debt + long term debt – Cash
Capital employed comprises the funds provided by shareholders and debt
holders. Consequently, when calculating return on capital employed,
the earnings figure used is earnings before interest and tax. That is, as a
measure of earnings before debt-holders and shareholders have received
any interest or dividend distributions.
The current debt measures include only debt raised as financing and not
in the course of conducting business. Two tests can be employed to see
whether liabilities are for the purpose of financing or operations.
1. Is the debt interest-bearing? This test excludes most trade creditors.
However, zero coupon are not excluded by this test.
2. Motive: does the liability arise in conjunction with another transaction
conducted in the course of business?
Return on equity = Earnings/Shareholders’ funds
Return on equity measures the performance of the firm from the
perspective of its shareholders.
This ratio measures the return on the capital provided by the firm’s
shareholders only. The net income figure reflects the profits attributable
to equity holders, after payment of interest and taxes. Note the difference
with return on capital employed (ROCE).
Activity 12.2
Using your BA data, calculate ratios 1–6.
12.5 The profitability equation
A major advantage of the return on capital employed and of return on
equity is that these ratios decompose into other ratios enabling a deeper
and integrated analysis of performance.
ROCE = EBIT/Capital employed
ROCE = EBIT/Sales * Sales/Capital employed
ROCE = Margin * Asset turn
The decomposition of these return on investment ratios facilitates analysis
of the factors driving investors’ returns.
Margin measures the difference between the prices at which the firm sells
its product and the cost of production.
Asset turn is a measure of efficiency: how well the firm utilises its capital
in generating sales.
12.6 Margin ratios
Different profit margins assess the relationship between revenue and
different types of expense incurred by the firm in conducting its business.
Gross profit margin focuses on the cost of making goods ready for sale
before any sales, general and administrative or depreciation expenses.

102
Gross profit margin = Gross profit/Revenue
Net profit margin focuses on profit from trading but before interest and
taxes.
Net profit margin = Operating profit/Revenue
British Airways’ net profit margin
£ million 2008 2007
Operating Profit 875 556
Revenue 8,753 8,492
Net profit margin 10.0% 6.5%
Sales margin examines the profit after financing costs and taxes.
Sales margin = Earnings/Revenue
Sales margin = Net profit after interest and tax/Revenue
British Airways’ sales margin
£ million 2008 2007
Profit after tax 694 304
Revenue 8,753 8,492
Sales margin 7.9% 3.6%
12.7 Efficiency ratios
Efficiency ratios calculate the efficiency of a company in organising its
activities. Efficiency ratios examine how good the firm is in ensuring that
capital is not needlessly tied up in unproductive assets.
Inventory represents goods that have been finished and could be sold
for cash. The inventory turnover ratio measures how good the firm is in
converting inventory into cash.
Inventory turnover ratio = Cost of goods sold/Inventories
The fixed assets turnover ratio measures how well a company uses its fixed
assets to generate sales.
Asset turnover ratio = Total sales revenue/Assets
This ratio highlights how well a company has used its assets to generate
sales. This type of ratio is best considered as a trend over a number of
years.
12.8 Leverage ratios
Financial leverage refers to the capital structure of the firm. It reflects a
fundamental financing decision relating to how much of the assets should
be funded by equity or debt. It is sometimes also called ‘financial gearing’,
or ‘gearing’.
Creditors are interested in the sufficiency of the assets to meet their
claims, which are prior to those of shareholders.
Equity to total assets ratio = Equity/Total assets = 1 – Total
liabilities/Total assets
Debt ratio (gearing ratio) = Net debt/Capital employed
Since the debt ratio deducts cash from loans, this may make cash-rich
firms look relatively unindebted, when in fact creditors may not be able to
offset the loan against cash.

103
The Debt to equity ratio = Debt/Equity, which does not deduct the cash
from the debt figure, is a good comparator.
12.9 Solvency and liquidity ratios
Solvency and liquidity ratios measure the ability of a firm to meet its most
immediate liabilities. The firm holds cash in the bank. Further, cash will
flow to the firm most immediately from sale of stocks and cash collected
from customers.
Current ratio = Current assets/Current liabilities
The acid test excludes inventories from the determination of current
assets, as it is the least liquid current asset.
Acid test = (Current assets – Inventory)/Current liabilities
Interest cover = EBIT/Net interest payable
The gearing ratios focus on gearing as reflecting the composition of the
balance sheet. The interest cover ratio assesses the degree to which the
interest payments that the firm has to make are covered by its earnings.
BA’s interest cover
(£ million) 2008 2007
Finance costs 175 168
– Bank interest receivable 111 129
= Net interest payable 64 39
Earnings before interest & tax 875 556
Interest cover 875 / 64 556 / 39
13.7 times 14.3 times
Activity 12.3
Update the data on BA’s interest cover to the current year.
Loan covenants will often specify a minimum interest cover that the firm
must maintain, and if that limit is breached, this triggers a legal default.
There are a number of reservations to be made about the use of all of
the above ratios. First, they are based on historical data, mostly about
costs, and such historical relationships may not continue; the value of
ratio analysis for predicting future performance should be borne in mind.
Second, they rely mostly on year-end data, so intra-year variations are
not tracked. Third, companies may not be comparable in terms of ratios;
the airline industry or hotels have high operating leverage, while trading
businesses have low operating leverage. Usually we need to add to the
ratios other information in order to do more detailed investigation.
In this chapter we have defined and examined the key ratios you will need
to examine key dimensions of the performance of the firm.
The key ratios relate to:
• investment
• profitability
• margins

104
• efficiency
• financial leverage
• solvency and liquidity.
We have defined these ratios and shown, where relevant, how they
interrelate. We have introduced data from specific case examples to
illustrate how the ratios work.
• describe the meaning of different financial ratios
• explain their application in conducting financial analysis of firms.
Suppose that Company 1 and Company 2 have the same financial
statements and that they are both attempting to acquire a third company
(by issuing shares of their company). Company 1 accounts for business
combinations using an acquisition method of accounting and amortises
goodwill over a ten year period. Company 2 utilises a pooling method of
accounting. How would the financial ratios of these two firms differ should
they be successful in conducting the acquisition, assuming that the price
paid for the third company significantly exceeds both its book value and
current market price? Which ratios would be unaffected?

Chapter 13:The origins of modern strategy
105
Chapter 13: The origins of modern
strategy
• discuss the core concepts of business strategy
• describe the main elements of the Porter framework
• outline the strengths and limitations of the approach.
Porter, M.E. ‘The five competitive forces that shape strategy’, Harvard Business
Review, January 2008, pp.78–93.
Willman, Chapter 6.
Grant, R.M. Contemporary strategy analysis. (Chichester: John Wiley & Sons,
2012) [ISBN 9781119941880].
Porter, M.E. Competitive strategy: techniques for analysing industries and firms.
(New York: Macmillan, 1980) [ISBN 9780684841489].
Whittington, R. What is strategy – and does it matter? (Ontario: Thomson
International, 2000) second edition [ISBN 9781861523778].
13.1.4 Works cited
Ansoff, I. Corporate strategy. (New York, NY: McGraw-Hill, 1965)
[ISBN 9780070021112].
Boston Consulting Group Strategy alternatives for the British motorcycle
industry. (London: Her Majesty’s Stationery Office, 1975)
[ISBN 9780100090651].
Chandler, A. Strategy and structure: chapters in the history of American
enterprise. (London: MIT Press, 1962) [ISBN 9781587981982].
Mintzberg, H. The rise and fall of strategic planning: reconceiving
roles for planning, plans, planners. (New York: Free Press, 1994)
[ISBN 9780029216057].
Mintzberg, H, B. Ahlstrand and J. Lampel Strategy safari: a guided tour through
the wilds of strategic management. (New York: Simon and Schuster, 2005)
[ISBN 9780743270571].
Pettigrew, A. The awakening giant: continuity and change in Imperial Chemical
Industries. (Oxford: Blackwell, 1985) [ISBN 9780631133568].
13.2 Two key definitions of ‘strategy’
The business strategy field is relatively new (from the 1960s), but as we
will see in the next five chapters, it has some controversial aspects, not
least about what the term ‘strategy’ means. The first definition below from
the business historian widely regarded as the ‘founder’ of strategy focuses
on management; the second, from a major critic, focuses on markets:
The determination of the basic long-term goals and objectives
of an enterprise and the adoption of courses of action and the
allocation of resources necessary for carrying out these goals.
(Chandler, 1962, p.13)

106
Strategic decisions are primarily concerned with external rather
than internal problems of the firm and specifically with the
selection of the product-mix that the firm will produce and the
markets to which it will sell.
(Ansoff, 1965, p.18)
The first definition focuses on factors internal to the firm, particularly
the management process. The second focuses externally on markets. The
quotes illustrate two main themes in the business strategy field. Chandler
and his followers look at resources and capabilities. Others, often with a
background in economics, look at how to position the firm in the market.
However, all of the early approaches to strategy were characterised by the
following.
1. Commitment to profit maximisation: the objective of strategy is to
maximise long-term returns and profits for the firm.
2. Separation of strategy conception from execution: senior
managers are primarily concerned to formulate strategies that others
implement.
3. Attachment to rational analysis: managers and firms act like
conventional economic agents.
4. A prescriptive approach: for example, there are things that firms
should and should not do.
5. Oligopolistic competition: strategy is broadly about how firms create
and appropriate economic rents.
(Mintzberg et al., 2005; Whittington, 2000)
Firms may have different strategic ‘goals’. For example:
• NASDAQ: ‘To build the world’s first truly global securities market.
A worldwide market of markets built on a worldwide network of
networks, linking pools of liquidity and connecting investors from all
over the world, assuring the best possible price for securities at the
lowest possible costs.’
• Unilever: ‘Our purpose in Unilever is to meet the everyday needs of
people everywhere – to anticipate the aspirations of our consumers
and customers and to respond creatively and competitively with
branded products and services which raise the quality of life.’
It should be noted that these two examples imply that firms may be
committed to something more than or different from simple profit
maximisation.
Later approaches (e.g. Minztberg, Pettigrew) raised two big questions.
First, in a stream of publications (e.g. 1994, 2005), Mintzberg has
questioned whether firms do have rational approaches to both the selection
of strategic objectives and the process by which these decisions are made.
He has referred to ‘emergent’ strategies in which conception and execution
are not separated. A well-documented case of Honda motorcycle success in
the USA has been used to illustrate the two processes (see Grant, 2012).
• One set of analysts, the Boston Consulting Group, argued that the
Japanese had developed huge production volumes in their domestic
market and volume-related cost reductions had followed. This resulted
in a highly competitive cost position which the Japanese used for
the penetration of world markets with small motorcycles in the early
1960s, particularly the USA (Boston Consulting Group, 1975).

107
• Later interviews with those involved suggested that the small
motorcycles that were the basis of success unexpectedly became
popular, particularly in California, with people such as surfers who
had not owned bikes before, and were sold through sports stores not
motorcycle dealerships. Success came from capitalising quickly on an
unexpected development.
Pettigrew, in a large-scale study of the British chemical firm ICI, focused
more on the strategy process, seeing this as a partly rational, partly
political process embedded in the culture of the firm. Not only were
processes more complicated than traditional prescriptive strategy schools
assumed, strategy was often focused on multiple, sometimes competing,
objectives. We must bear these issues in mind in the discussions of the
main strategy schools that follow.
13.3 Porter and the five forces
Michael Porter was for many years the dominant strategy academic. He
argued:
The essence of formulating competitive strategy is relating
a company to its environment. Although the relevant
environment is very broad, encompassing social as well as
economic forces, the key aspect of the firm’s environment is the
industry or industries in which it competes.
(Porter, 1980)
Some industries were more profitable than others, and within industries
some firms were better positioned. Both industry profitability and
the profitability of the firms’ position could be understood in terms of
competitive forces. These are shown in Figure 13.1.
Figure 13.1: Porter’s five forces
Suppliers
- Number of suppliers
- Size of suppliers
- Switching costs
- Unique service/product
- Ability to substituteBarriers to entry
- Time and cost of entry
- Knowledge
- Economies of scale
- Cost advantages
- Technology
- Barriers
- Substitute
performance
- Cost of switching
- Buyer willingness
Substitutes
Competitive rivalryBuyers
- Number of competitors
- Exit barriers
- Niche, quality
- Differentiation
- Switching costs
- Industry concentration
- Diversity of competitors
- Number of customers
- Buying volumes
- Differentiation
- Price elasticity
- Incentives
- Brand identity
- Switching costs
STRATEGIC
POSITION

108
The basis for this approach is industrial economics, specifically the
‘structure–conduct–performance’ approach in which an industry can
be examined by the number of firms, homogeneity of product, entry
and exit conditions (structure), the strategies firms pursue (conduct)
and performance – the firm and welfare performance indicators. Porter
turns this model around to focus on how firms can create rents by
understanding and manipulating the five forces. Where they do so
successfully, they can create ‘competitive advantage’.
We can think of the approach as operating in two stages. Consider Table
13.1 below, which shows industry profitability at the turn of the century
for the USA, then the largest economy.
US Industry in 2001 Return on equity
Banks 11.2%
Cinemas 5.7%
Computers 26.4%
Grocery stores 18.4%
Hospitals 1.4%
Hotels 9.8%
Natural gas production 0.7%
Newspapers 25.2%
Soaps and cosmetics 33.7%
Tobacco 0.0%
Table 13.1: Profitability of major US industries in 1999–2000
Some industries are unprofitable in the long term. It has been claimed that
in the first hundred years of US air travel (1903–2003) the industry made
exactly zero cumulative profit (Financial Times, 22 November 2003). An
industry analysis of profitability may thus lead to a strategy of industry
exit. However, firms within an industry may also vary in performance.
For example, in the same year, return on equity in the computer industry
varied from 80 per cent (Dell) to 1 per cent (Apple). This was prior to
the launch of iPods, iPhones and iPads, which arguably changed the
boundaries of the computer industry.
Within an industry – the second stage – firms can improve their
competitive position by analysing and manipulating the five forces.
In detail, the five forces are as follows.
13.3.1 Barriers to entry
These will be high where there are:
• high capital costs to enter
• no opportunity for small firm entry because of incumbent economies
of scale and scope or incumbent economies of vertical integration
• restricted access to distribution channels
• customer loyalty to incumbents
• restricted access to essential inputs
• threat of retaliation by incumbents
• excess capacity.

109
13.3.2 Competitive rivalry
This will be high where there are:
• low industry growth
• commodity products and services
• low brand loyalty
• low switching costs
• excess capacity
• high exit barriers.
13.3.3 Power re buyers
The firm is powerful with respect to its buyers (customers) where:
• the product or service is differentiated or unique
• the product/service is essential to buyers
• buyers have few alternative sources of supply
• buyers have high switching costs
• buyers have no substitutes available
• the firm can integrate forward to purchase the buyer
• the firm is larger than its customers.
13.3.4 Power re suppliers
The firm is powerful with respect to its suppliers where:
• the supplier’s input is a commodity
• the supplier’s input is inessential to firm output
• the firm comprises a large proportion of supplier’s sales
• the supplier has many competitors
• the supplier has few other customers
• the firm has low switching costs
• the firm has substitute products available
• the firm can integrate backward to purchase the supplier
• the firm is larger than the suppliers.
13.3.5 Threat of substitutes
The threat of substitutes is high where:
• alternative products or services deliver either:
comparable benefits at lower cost, or
fewer benefits at significantly lower cost
• new technology can make product or service obsolete
• customers have low switching costs.
Analysing the five forces does at least two things for the firm. It allows an
estimate of current profit possibilities and it opens up the prospect that the
firm can alter its industry position to its own advantage. The conventional
way this is done is in Figure 13.2. The axes are measured and positions
plotted; when the axes are joined, the larger the area, the more attractive
the industry. The position can then be managed in order to generate
competitive advantage. At the extreme, this might suggest exit behaviour,

110
but it can be used as an indicator of what to protect and where the major
competitive risks lie. It is not simply about defence, it also points to what
aspects of the industry structure the firm might try to influence. For the
diversified firm, it points towards effective portfolio management, guiding
market entry as well as exit considerations. So the optimal competitive
position, indicated in the figure, is where entry barriers are high, rivalry
is low, the firm dominates both suppliers and buyers and there is no
substitute product or service available.
Activity 13.1
Perform a five forces analysis for Apple, Nike or Coca-Cola.
This approach has been extremely influential, but it is worth mentioning
several limitations, noted by a variety of critics (see Willman, 2014,
Chapter 6).
1. Although strategy is by definition forward-looking, the analysis of the
five forces is retrospective.
2. There is no model, for example, of how to implement, following
industry analysis, policies or practices that might lead to competitive
advantage.
3. It assumes that a bounded ‘industry’, distinct from others, exists.
This is perhaps much more likely in mature rather than fast-growing
sectors.
4. The firm is not seen as a complex organisation but rather as a chess
piece to be moved around an industry board.
5. In consequence, there is no model of the decision-making process in
particular or the strategy process more generally.
6. The firm may be able to identify the optimum competitive position,
but the model does not cover its capability to occupy it.
7. There is no dynamic of competition. Specifically, it does not model
events where several firms are trying to occupy a similar position.
Figure 13.2: Star plot of industry structure
Activity 13.2
Perform a star plot analysis for Apple, Nike or Coca-Cola.
Entry
barriers
Rivalry
LowLow
HighHigh
Power re
suppliers
Power re
buyers
Threat of
substitutes
High

111
In this chapter we have looked at:
• different meanings of the term ‘strategy’ in the business literature
• the logic of the Porter framework.
We have also itemised the five forces identified by Porter and indicated
how the five forces framework may generate competitive advantage for
the firm. Finally, we have examined the strengths and weaknesses of the
approach.
• discuss the core concepts of business strategy
• describe the main elements of the Porter framework
• outline the strengths and limitations of the approach.
What does competitive advantage mean and how can a firm achieve it?

Notes
112

Chapter 14: Understanding organisational structures
113
Chapter 14: Understanding organisational
structures
• outline the main types of organisational structure within firms
• discuss the basic principles of organisational design
• describe the relationship between organisational structure and
strategy.
Willman, Chapter 5.
Mintzberg, H. Structure in fives: designing effective organisations. (Harlow:
Prentice Hall, 1983) [ISBN 9780138554798] pp.1–25.
Pfeffer, J. New directions for organisational theory. (Oxford: Oxford University
Press, 1997) [ISBN 9780195114348].
Scott, W.R. Organisations: rational, natural and open systems. (Harlow: Prentice
Hall, 1997) fourth edition [ISBN 9780132663540].
14.1.4 Works cited
Albrow, M. Bureaucracy. (London: Macmillan, 1970) [ISBN 978033311265].
Fayol, H. General and industrial management. (London: Pitman,
1916) (Financial Times/Prentice Hall, revised edition, 1988)
[ISBN 9780273029816].
Gouldner, A. Patterns of industrial bureaucracy. (Glencoe, IL: The Free Press,
1954).
Hamel, G. The future of management. (Boston: Harvard Business Review Press,
2007) [ISBN 9781422102503].
Nonaka, H. and I. Takeuchi The knowledge-creating company. (Oxford: Oxford
14.2 Introduction
As we saw in Chapter 1, early writing on the structure of business
organisations was influenced by prior thinking about how large
organisations, such as the church and, particularly, the state, operated. The
central concept of bureaucracy, articulated by Max Weber in the early 20th
century, was designed to explore and characterise the attributes of efficient
public administration. This is some distance from the modern colloquial
use of the term ‘bureaucracy’, which implies inflexibility and inefficiency
(Albrow). The core idea behind bureaucracy was rationality – specifically,
that an organisation could be structured around universal principles which
ensured effectiveness.

114
Principle Application Goal
Standardisation Minimise variance from
standards around inputs,
outputs and work methods.
Pursue scale economies,
manufacturing efficiency,
reliability and quality.
Specialisation of tasks
and functions
Group like activities together in
modular organisational units.
Reduce complexity and
accelerate learning.
Goal alignment Establish clear objectives
through a cascade of
subsidiary goals and
supporting metrics.
Ensure individual efforts
are congruent with top-
down goals.
Hierarchy Create a pyramid of authority
based on a limited span of
control.
Maintain control over a
broad scope of operations.
Planning and control Forecast demand, budget
resources, and schedule
tasks, then track and correct
deviations from plan.
Establish regularity and
predictability in operations
and conformity to plans.
Extrinsic rewards Provide financial rewards to
individuals and teams for
achieving specified outcomes.
Motivate effort and
ensure compliance with
policies and procedures.
Table 14.1: Guiding priciples for a standard orgamisational structure
14.3 Organisational design
In application to business organisations, ideas similar to Weber’s were
articulated by Fayol (1916) who suggested that the guiding principles for
designing an organisation should be:
• tightly prescribed roles: there should be a division of labour that
makes individual responsibilities clear
• high degree of specialisation, to enable the development of expertise
• clear and explicit formal procedures to ensure rationality and
accountability in decision-making
• clear and explicit hierarchy, so that reporting relationships are clear
• promotion based on defined criteria, to eradicate favouritism and
corruption.
These are very general principles, and Fayol’s assumption was that it was
possible to find one best, universally applicable, approach.
Despite the fact that modern organisational design does not favour ‘one
best way’ approaches, some of the general components of this early
approach have retained currency. Hamel (2007) characterises the core
components of this approach (as in Table 14.1) and, while acknowledging
the longevity of this approach, he expresses concerns about its relevance to
21st-century organisations.
The modern approach stresses organisational structure as the consequence
of design choices (Scott, 1997). The choices that any organisation has to
make can be understood as part of ‘organisation design’, including, but not
restricted to:
• workflow relationships – how production is organised
• communication relationships – how information is transferred
• reporting relationships – how authority is distributed

115
• the boundary of the firm – its relationship to labour, product and
capital markets
• modularity of the firm – what are the core building blocks?
At any point in time, the organisation may be seen as experiencing a
tension between two competing processes.
14.3.1 Differentiation
Organisational structure divides the task of the organisation as a whole
into manageable subtasks, and allocates them to units that are held
responsible for their completion.
14.3.2 Coordination
Organisational structure ensures that the different subtasks are integrated
and controlled in a way that results in the organisation achieving its tasks.
Organisational design is the process of creating a structure which attempts
to reconcile these twin tensions.
As we saw in the previous chapter, for Chandler, organisational structure
follows from firm strategy, thus strategic choices imply and constrain
design choices. Five key questions need to be answered.
1. Where should the organisation’s boundaries be?
2. How should work be divided and combined?
3. What are the lines of authority and communication?
4. How much bureaucracy do we need?
5. How do we leverage what we know?
We will look at each in turn, briefly outlining the key issues.
14.4 Organisational boundaries: the issues
The firm market boundary is a central issue for the theory of the firm. In
design terms, there are four major issues:
• Relations with customers and suppliers. These are key issues
for the Porter framework we analysed in the previous chapter. The
choice is essentially between making (vertical integration) or buying
(relationship management).
• Relations with competitors and collaborators. At base, this
is the horizontal integration counterpart to the vertical integration
problem. However, there are two complicating factors. First, there are
many intermediate stages between competition and acquisition – joint
ventures, alliances and networks exist in many industries. The second
complexity is that in many sectors firms both compete and collaborate
with each other at the same time.
• Diversification. Broadly, this is movement into other sectors
which may be related or unrelated. This is usually underpinned by
divisionalisation and the adoption of an M-form organisation (see
Chapter 9).
• Governmental and regulatory relationships. There are very
few businesses that do not experience some form of government
oversight, even if only in the production of financial accounts. For
many firms, considerable resources have to be devoted to managing
legal and regulatory matters.

116
So the boundary decision is a (constrained) decision about two related
matters. First, it is about the location of the firm’s boundaries, and, second,
about what kind of internal roles are created in order to manage boundary
relationships.
14.5 Division of labour: the issues
Grouping by
Functions
(means)
Markets
(ends)
Knowledge/Skill set
Work processes
Product
Customer segment
Place
Figure 14.1: Supply-side versus demand-side organisation
The division of labour is the process that sets the balance between
integration and differentiation. In Figure 14.1 the firm must decide on the
balance between organising around the supply side (means and functions)
and the demand side (ends and markets). In practice, both considerations
are important, but on either side, there are choices to be made. On the
supply side one can organise around functions (e.g. finance) or processes
(e.g. smelting, assembly). On the demand side, one can organise around
product groups, market segments (see Chapter 19) or geography.
They key issues are complexity and priority. Using all five of the criteria on
the right-hand side of Figure 14.1 will result in an extremely complex and
probably unworkable organisational structure. So a choice must be made
and the priority is driven by the organisation’s strategy.
14.6 Authority and communication: the issues
There are both ‘formal’ and ‘informal’ issues to consider in designing
authority structures within a hierarchy. The formal issues would be
familiar to Fayol, and will be evident from the analysis of an organisational
chart. Three key issues are:
1. Spans of control: each authority position in a hierarchy has a number
of direct reports, and the number of direct reports is limited by the
supervisory requirements of each post. This has implications for the
number of levels in a hierarchy. De-layering in order to reduce costs
will have implications for spans of control.
2. Reporting relationships: in most organisations, reporting relationships
need to be both lateral and vertical – this leads to the emergence of
matrices, which are discussed below.
3. Ease of communication: communication and authority relationships
overlap but are not identical and consideration must be given to the
information requirements of roles within the organisation.

117
There are also three key informal issues:
1. Power and authority: authority in hierarchies is primarily dependent
on position, but power may reside in any role which has control
of a key resource or bottleneck. Where such a monopoly emerges,
then the possibility exists that ‘single point failure’ will cause major
organisational problems − control over distribution within many
organisations is an example. In this case, duplication of roles may be
considered.
2. Careers and career progression: hierarchies are also career ladders
and the number of ‘rungs’ on such ladders may become important
for motivation and retention. Extremely ‘flat’ organisations may be
advisable for efficiency purposes but may cause other problems.
3. Centralisation and decentralisation: the organisation must be designed
with the distribution of decision-making responsibility in mind.
Decentralised organisations are often more adept at responding to
market changes, but decentralised organisations tend to have higher
costs (through duplication), lower information sharing (through
fragmentation) and a higher demand for managerial skills.
14.7 Bureaucracy: the issues
Bureaucracy (proliferation of formal rules) has a tendency to increase
in firms through a ‘dynamic’ in which rule avoidance is followed by the
establishment of more and more stringent rules (Gouldner, 1954). The
most important set of rules concern the coordination of tasks and these
have been categorised by Mintzberg (1983) as follows:
• Mutual adjustment refers to the process of mutual accommodation
between task performers as members of a team. It works best in small
teams (up to 6–7 people) but breaks down in larger groups through
the transaction costs of coordination.
• Direct supervision refers to the direct observation of role
performance. As we showed in the analysis of Taylorism in Chapter 3,
it is effective but costly.
• Standardisation of work processes refers to the specification
of precise role performance by rule. For example, in the operation of
McDonald’s franchises, the preparation of a hamburger is standardised
by detailed rules about content, cooking and presentation in order to
ensure that variance is eradicated. Where variance is desirable, such
standardisation may have negative consequences.
• Standardisation of outputs refers to the specification of the
output characteristics of one part of the organisation where those are
inputs to another part. This allows flexibility of process.
• Standardisation of knowledge/skills occurs where processes
are highly variable and outputs are difficult to specify ex ante.
Organisations may rely on standardisation of knowledge inputs. A
good example would be professional service firms in law, accountancy
and medicine, where professional training and standards are prime
coordinating devices.
14.8 Know-how: the issues
From one perspective, organisations may be considered as bundles of
knowledge or know-how. From this perspective, two firms with identical
knowledge may perform differently depending on differences in their

118
ability to leverage that know-how. Nonaka and Takeuchi (1995) make
the distinction between explicit or codified knowledge on the one hand,
and tacit or ‘sticky’ knowledge on the other. Figure 14.2 illustrates the
processes that a firm may use to augment both.
Tacit Explicit
Tacit Explicit
Documentation
Combination
Learning
Socialisation
Figure 14.2: Leveraging explicit and tacit knowledge
The four key processes are:
• turning tacit know-how into explicit knowledge by documenting best
practice and disseminating it
• combining explicit knowledge from different parts of the organisation.
In this approach, new combinations of existing explicit know-how are
seen as a major source of innovation
• building on existing explicit know-how by creating new tacit know-
how through learning by doing
• preserving and transmitting difficult to codify tacit knowledge by
socialising new entrants to the firm.
14.9 The components of organisation
Mintzberg (1983) has classified the components of the organisation in
a five-fold schema and extended this into a five-fold classification of
organisations characterised both by a dominant coordinating device and
dominant component.
• A typical simple structure would be a small entrepreneurial firm with
the entrepreneur providing both overall direction and supervision.
• A typical machine bureaucracy would be a large industrial firm in
which scale economies are gained through standardisation.
• A typical divisionalised structure would be an international business
(see below).
• A typical professional bureaucracy would be a large law or accounting
firm.
• A typical adhocracy would be a project-driven structure in which the
continuity is provided by support staff around a changing operational
core. Mintzberg himself uses the example of a film studio operating
with changing actors, directors and scripts.
We noted above that many firms move to a structure termed ‘matrix’
involving two (or multiple) lines of reporting. An example is given
in Figure 14.3, which graphically shows the structure of ABB, a well-
developed matrix. The two main organising principles are product group,

119
on the one hand, and geography on the other. ABB generates economies of
scale in product design and manufacture. On the other hand, it deals with
large infrastructure projects where clients are governments with different
needs and practices, so country managers become important.
Generically, four sets of pressures characterise the move to a matrix
organisation, as follows.
1. The need to respond to at least two sectors simultaneously (e.g.
markets/technology).
2. When firms face external uncertainties needing high information-
processing requirements.
3. When firms face strong financial/human resource constraints – for
example, consulting.
4. When flexibility and balanced decision-making is more important than
the costs of complexity.
Figure 14.3: ABB: a matrix in practice
Activity 14.1
Go to the ABB website and find the organisational chart: how has it changed?
14.10 The ‘M’ form
We briefly described the ‘M’ (multi-divisional) form in the context of
performance measurement in Chapter 9. Here we deal with the design
issues of the structural form. The figure below shows the contrast between
the functional (‘J’ form) and the M form organisation.
Percy Barnevik CEO
(1988–1996)
12 (later 7) – strong executive
committee
Group functions and financial services
Production divisions
Regional/
National
operations
Europe
Americas
Asia Pacific
Powertransmission
anddistribution
Powerplants
Industrialandbuilding
systems
Transportation

120
Figure 14.4: The ‘M’ form organisation
The latter is characterised by the following:
• distinct market-based groupings
• operating functions quasi-autonomous, reporting to a head office
• vertical decentralisation to divisional managers
• autonomous decision-making subject to the performance controls we
discussed in Chapter 9.
There are several key organisational design issues within the M form.
Two of these we will discuss here. First, when fixing the basis for creating
divisions, the firm must decide what the nature of the quasi-autonomous
businesses must be. The two most common criteria are product group or
geography. Then it must make the choice of how to measure divisional
performance; this involves the choice of measure but also the decision
about whether to use one measure or several.
There is variance between M form organisations in the role taken by
headquarters. The following six functions may be performed.
1. Manager of strategic portfolio: HQ simply decides which autonomous
divisions to own. This is a minimalist role and if it is the only one
performed, the M form is really just a holding company.
2. Allocator of financial resources: this is the internal capital market
function of HQ. It may simply allocate according to performance, in
which case high-performing divisions retain most of their earnings, or
allocate according to some strategic plan.
3. Owner of performance control system: we have dealt with many of
the issues here in Chapter 9, but the key point is that the performance
system must be controlled independently of the divisions being
controlled.
4. Appoints/replaces managers of divisions: this is the ultimate
performance sanction available.
5. Personal monitoring of divisional performance by Board members; this
practice reduces the information asymmetries between divisions and
HQ.
6. Support services: HQ may centralise certain functions (e.g. HR,
investor relations) in order both to retain control and prevent
duplication.
The Multidivsional (’M Form) Corporation:
Trading Efficiancy for Span of Operations
Functions
Functions Functions Functions
Divisions
(product/
geographic)
Functional structure
(report by functions
e.g. marketing, production)
Divisional structure
(report by businesses)

121
The chapter has examined structural and design options for firms.
Beginning with the Weberian concept of bureaucracy, it has discussed
the development of formal rational hierarchies in business. It covers the
work of Mintzberg and Scott on organisational structure, and outlined the
design implications. It has described the matrix form and indicated the
conditions for its emergence. It has examined the M form and indicated
the main design options.
• outline the main types of organisational structure within firms
• discuss the basic principles of organisational design
• describe the relationship between organisational structure and
strategy.
Why did the ‘M’ form organisation become so common in industrial
enterprises in the 20th century?

Notes
122

Chapter 15:The analysis of organisations
123
Chapter 15: The analysis of organisations
• describe some main currents in organisational theory
• relate these to current debates in business strategy.
Pfeffer, J. New directions for organization theory: problems and prospects.
(Oxford: Oxford University Press, 1997) [ISBN 9780195114348],
Conclusion.
Han, S.K. ‘Mimetic isomorphism and its effects on the audit services market’,
Social Forces 73 1994, pp.637–63.
Hannan, M. and J. Freeman ‘The population ecology of organisations’,
American Journal of Sociology 82 1977, pp.929–64.
Podolny, J. Status signals. (Princeton: Princeton University Press, 2008)
[ISBN 9780691136431] Introduction and Chapter 1.
Williamson, O.E. ‘Comparative economic organisation: the analysis of discrete
structural alternatives’, Administrative Science Quarterly 36(2) 1991,
pp.269–98.
15.1.4 Works cited
Di Maggio, P. and W. Powell ‘The iron cage revisited: institutional isomorphism
and collective rationality in organisational fields’, American Sociological
Review 48 1983, pp.147–60.
Donaldson, L. American Anti-management theories of organisation: a critique
of paradigm proliferation. (Cambridge: Cambridge University Press, 1995)
[ISBN 9780521479172].
McKenna, C.D. The world’s newest profession: management consulting in
the twentieth century. (Cambridge: Cambridge University Press, 2006)
[ISBN 9780521810395].
Meyer, J. and B. Rowan ‘Institutionalised organisations: formal structure as
myth and ceremony’, American Journal of Sociology 83 1977, pp.343–60.
Weber, K., G. Davis and M. Lounsbury ‘Policy as myth and ceremony? The
global spread of stock exchanges 1980–2005’, Academy of Management
Journal 52(6) 2009, pp.1319–47.
Whittington, R., M. Mayer and F. Curto ‘Chandlerism in post-war Europe:
strategic and structural change in France, Germany and the UK, 1950–
1993’, Industrial and Corporate Change 8(3) 1999, pp.519–51.
Zey, M. Rational choice and organizational theory: a critique. (Thousand Oaks,
CA: Sage Publications, 1998) [ISBN 9780803951365].
15.2 Strategy and organisational theory
Industry structure approaches to strategy such as Porter’s do not
particularly need a theory of organisations since they treat the firm as a
single decision point – a piece on a chessboard, so to speak. However, both
the Chandlerian and resource-based theories discussed in the next chapter
have to address organisational issues, as does any concern with strategy

124
implementation. The Oxford English Dictionary defines strategy as follows
‘… as in the theory of games, decision theory, business administration, etc.,
a plan for successful action based on the rationality and interdependence
of the moves of the opposing participants’. This includes participants
within the organisation, so therefore many strategy theorists begin with a
consideration of how organisations operate.
Up until the 1960s the dominant paradigm in organisational research was
structural contingency theory. Its central premise was that organisations
adapted structures to deal with ‘contingencies’ such as technology, size and
(following Chandler) strategy.
Managers within organisations were depicted as the structuring and
adaptive agents manipulating organisational characteristics to improve
performance (Pfeffer, 1997, pp.158–63). Managerial agents were seen
as benign and rational. Organisations in turn were seen as rational and
purposeful systems. A positive correlation was assumed between fit and
organisational performance; managers were the adapters of fit. Fit could
be optimised in equilibrium.
Specific propositions emerged about organisational components. For
example, bureaucracy and centralisation were seen as functions of
technology, size and rate of change. Matrices were defined by rate of
change and product diversity. Functional or divisional structure was
defined by strategy and size. The method chosen was frequently multiple
regression analysis with the organisational feature requiring explanation
treated as the dependent variable (Donaldson, 1995).
In the 1960s, primarily in the USA, this picture of organisational
rationality and managerial benevolence was attacked from a number of
directions. Organisations were characterised as political systems – the
key notions were power, inertia, bounded rationality and legitimacy.
In addition, approaches within economics such as transaction cost
economics and agency theory (discussed above) served either to demonise
managerial agency or to downplay its significance (Donaldson, 1995).
All critical approaches debated whether managerially initiated strategy
was feasible or desirable.
Many critiques stressed conceptual difficulties with the rational choice
approach to organisational analysis. In this approach the individual is
the unit of analysis; the individual is prior to and causes the collective.
Individual choices are independent; collective action is aggregate
individual action. The critique of rational choice (Zey, 1998) asserts
that rational choice approaches to organisation have too restrictive and
unrealistic assumptions. Zey (1998) lists the following.
• Individuals have rational preferences; they are complete and transitive.
• Economic man is also selfish; all forms of altruism are subtle self-
interest.
• Preferences are revealed in choices; for example, actions are
preferences – ‘the causal relation is from the action to the subjective’.
• Choice is rational if the outcome is rational. Process is not important.
• Value and utility are subjective.
• Organisations function rationally; for example, means–ends
relationships are pursued, efficiency is maximised, decision-making is
logical.
• Efficiency is not a contested concept; the market economy operates
independent of context.

125
• Power is a structural condition within economic transactions affecting
payoffs; authority emerges unproblematically from principal–agent
relationships.
Many approaches assumed rationality was bounded, or that social forces
exerted themselves on organisations that were at least as powerful as
economic ones.
15.3 Institutional theory
Institutional theory (Meyer and Rowan, 1977) starts from the two
premises that actors are boundedly rational and that social forces are
important. Specifically:
• Organisation form is driven by ‘institutional myths’. Organisations
adopt forms because of myths within an environment, as opposed
to because those myths are necessarily connected to more effective
organisational outcomes.
• They argue against the idea of the rational organisation. The authors
argue, instead, in favour of an idea of rationalised institutional
elements.
• Organisations are driven to adopt practices or routines in order to
achieve increased legitimacy and to increase their survival prospects,
and so that their adoption of these practices is not immediately
connected to any direct increase in efficiency.
• As rationalised institutional rules arise in given domains of work
activity, formal organisations form and expand by incorporating these
rules as structural elements.
• Organisations that incorporate legitimated, rationalised elements in
their formal structures maximise their legitimacy and increase their
resources and survival capabilities.
• The more an organisation’s structure is derived from institutionalised
myths, the more it maintains elaborate displays of confidence,
satisfaction and good faith, internally and externally.
• Institutionalised organisations seek to minimise inspection and
evaluation by both internal managers and external constituents.
DiMaggio and Powell (1983) do not describe firms as existing in markets,
but in ‘fields’. Fields do not operate primarily under market rules but
under social rules which emphasise legitimacy and conformity. There is
a tendency for firms in fields to homogenise, not through competition in
search of efficiency, but rather for firms subject to bounded rationality
to seek legitimacy through accommodation of pressures towards
isomorphism. Three types of isomorphism are identified.
1. Coercive isomorphism refers to pressure from the state or wider
society, possibly embedded in law, regulation or external codes of
conduct.
2. Mimetic isomorphism refers to imitation of one organisation
by another in order to be accepted as a legitimate field member,
or because, under bounded rationality, search for the appropriate
organisational form was minimised.
3. Normative isomorphism refers to items such as professional
socialisation, in which again legitimacy and conformity are prime
objectives.

126
Inter-firm competition emerges as a socially constrained activity, with
managers having limited ability to define strategies or structures that
would jeopardise legitimacy. There is a range of research arguing for the
applicability of this approach. For example, in his discussion of the growth
of management consultancy, McKenna (2006) asserts two examples of
institutionalism. First, he argues that the major management consultancy
firms adopted partnership governance structures primarily in imitation
of law firms and investment banks in order to enhance legitimacy by
association with a high-status organisational form. He goes on to offer
another isomorphic example in the operation of consultancy firms. He
suggests McKinsey exported the US divisionalised/diversified M form
model to Europe in the 1970s just as it was beginning to decline in the
USA. The agency for diffusion was not the enhanced efficiency properties
that Chandler and Williamson identified, but the social pressure to
conform with a structure advocated by high-status consultants. He points
out that McKinsey did not have an office in Spain because of concerns
about the political regime there, and Spanish firms divisionalised at much
lower rates until the regime changed in 1976.
As Figure 15.1 shows, diversification trends do show a lag effect between
the USA and Europe. The figure is part of an essentially institutionalist
argument about the influence of Chandlerism in post-War Europe, and
there is a major point to make here about the strategy literature in
general. The practical influence of academic business strategy, particularly
as it is put into practice by the major management consulting firms, is such
that the tenets of strategy may become self-fulfilling properties, creating
the trends they seek to theorise about.
Figure 15.1: The diversification of large industrial firms, USA and Europe
(domestically owned top 100 industrial firms)
Source: From Whittington, Mayer and Curto, 1999.
A second example of empirical work in institutional theory is the diffusion
globally of stock markets (Weber et al., 2009). They studied the creation
of stock markets in emerging economies and identified coercive, normative
and mimetic effects operating to different degrees in different countries.
In some, governments had set up stock markets and pressured firms to
list as part of a drive for economic development. In others, the initiative
came from businesses themselves, as they tried to emulate the benefits
– primarily the raising of capital – enjoyed by developed economies with
stock markets. They found that coercive effect dominance – for example,
*
*
*
* *
% of firms diversified
(related and unrelated) UK
90
80
70
60
50
40
30
20
10
0
1950 1960 1970 1983 1993
US
UK
Germany
France

127
the major role of governments – was associated with ceremonial, poorly-
performing exchanges, judged by activity indices such as listing and
trading volumes. By contrast, peer influence and normative emulation
enabled more vibrant activity levels.
That major features of business life such as divisionalisation, partnership
and stock markets can be attributed to the action of social forces is a
major departure from simple economic theories of business behaviour.
There are two major implications. First, the unit of analysis shifts from the
firm to the field. Second, the scope for independent managerial action is
downplayed in such approaches, raising questions about the integrity of
the idea of ‘strategy’ itself. We shall return to this below.
15.4 Organisational ecology
These two implications are shared by the approach of organisational
ecology – which borrows ideas from biology and ecology to study
organisations. In addition, it also takes collections of organisations, rather
than the single firm, as the unit of analysis. In organisational ecology,
these collections are termed ‘populations’. The approach examines
interactions within and between populations of organisations. It concerns
itself with patterns of birth and death of organisations and looks at
selection mechanisms and life histories. A key question is: why are there so
many kinds of organisation?
Key concepts include:
• density dependence, for example, the influence of population density
on birth and death rates
• legitimacy and competition, and their interaction as in institutional
theory
• niches, borrowed directly from ecology to mean a space on which an
organisational population may survive
• structural equivalence, for example, identical patterns of inter-
organisational ties.
Let us illustrate the approach with the canonical example – the analysis of
US labour unions between 1836 and 1985 (Hannan and Freeman, 1977).
The pattern of growth and decline is illustrated in Figure 15.2 below. As
unions are founded and their numbers grow, they gain legitimacy as an
organisational form and benefit from positive externalities which reduce
costs; density has positive effects in the growth phase. When population
size is larger, competition and resource constraints turn density-dependent
effects negative. Concentration occurs as ‘niche width’ stabilises and
death rates exceed birth rates. These selection effects are external to the
individual organisation, but generate patterns of change for the population
as a whole.

128
US labour unions
1840 1860 1880 1900 1920 1940
Year
1960 1980 2000
0
40
80
120
160
200
240
Numberoflabourunions
Figure 15.2: US labour unions
The approach has been replicated, notably with Silicon Valley firms and
US newspapers, which indicate similar patterns.
Activity 15.1
This is an optional extra acitivity for those of you who have access to Chapter 7 of Pfeffer
(1997). How does he describe the strengths of organisational ecology in that chapter?
15.5 Critique
There are some common features of institutional theory and organisational
ecology.
• In both, there is an assumption of internal organisational inertia – the
organisation does not respond to changes but reacts to external social
forces. The underlying assumption is based on elite dominance – that
elites within organisations have no incentive to change. This in turn
contains implicit ideas about power in a hierarchy, and Donaldson has
noted that these organisational theories are ‘anti managerial’ (1995).
• The unit of analysis is the population or field, not the firm, and it
is central to both approaches that any sources of variation in firm
structures within a field or population are not of primary interest.
• Social forces, not efficiency, explain the occurrence of common
organisational forms.
There are various critiques of both approaches, summarised in a review by
Donaldson (1995), as follows.
15.5.1 Institutional theory
• There are observable differences in organisational form within fields.
For example, within investment banking there was a lengthy period
when both partnerships and joint stock companies coexisted.
• Where do agency and change come from? To continue the investment
banking example, partnerships have disappeared, but it is difficult
from an institutional theory perspective to find a simple explanation.
• Empirical support is strong only for the effectiveness of coercive forces
– as in the stock market example.
• The relationship between isomorphism and performance variables
is unclear. We know that performance differences between firms in

129
a given industry persist, but whether better conformers are better
performers is not clear.
15.5.2 Organisational ecology
Some of these criticisms would also apply to organisational ecology, but in
addition:
• there is no theory of change, even isomorphic change, within
organisations
• there is no direct study of intra-organisational processes
• the randomness of selection processes is asserted, not proven – what is
the role of selection in death rates?
15.6 Organisational sociology and economics
There is a fundamental difference between these sociological approaches
to organisation and those based on economics. They may be summarised
as follows.
15.6.1 Sociology
• Organisations as types of institution.
• Organisations in fields and societies.
• Formal and informal structures, multiple empirical actors.
• Historical and path-dependent emergence.
• Rationality as a variable.
15.6.2 Economics
• Firm as production function then hierarchy.
• Firms in exchange relationships.
• Hierarchies with stylised actors.
• Profitable solutions to problems.
• Rationality as assumption.
Pfeffer has argued that economics has become a more powerful discipline
in the study of business organisations. He remarks:
It seems almost impossible to consider the evolution of
organisational theory, particularly in the future, without considering
the influence of economics on the field’s methods and substance.
(Pfeffer, 1997, p.14)
He attributes this to the focus on business organisations and in particular:
the location of much organisational studies in business schools…has
led to a substantial overemphasis of economic models and logic.
(Pfeffer, 1997, p.6)
He argues that there are a number of factors leading to the intrusion of
economics into organisational theory.
• Economics has a powerful, elegant theory allowing the building of
formal models of organisation, such as those based on agency theory.
• The growth of large firms and the share of economic activity that
takes place within firms lead to an increase in the importance of
organisational versus market behaviour.

130
• There is an increasing emphasis on performance and efficiency as the
main attributes of organisation, as opposed to non-economic features.
• The increasing impact of the practitioner business community that is
looking for performance-improvement tools.
• Fragmentation of organisational theory with many different
approaches based in sociology and psychology, rather than a unified
theory. Donaldson (1995) has termed this paradigm ‘proliferation and
incommensurability’.
Activity 15.2
What are to Pfeffer’s (1997) major criticisms of economic approaches to the study of
organisations?
This chapter has analysed the development of some modern theories of
organisation, dealing with both sociological and economic approaches
and examining ecological and institutional theories of organisational
fields, with empirical examples of each type of research. It has looked at
the connection between the study of organisational forms and fields, and
examined theories of organisation that imply restrictions on managerial
action.
• describe some main currents in organisational theory
• relate these to current debates in business strategy.
What is the contribution of institutional theory to an understanding of the
strategy and structure of large businesses?

Chapter 16: Contemporary strategic management
131
Chapter 16: Contemporary strategic
management
• describe the resource-based view (RBV) of the firm and its implications
for strategy
• discuss the dynamic capabilities approach to strategy formation
• explain the concept of core competence and its use
• describe the idea of an integrated strategy process.
Whittington, R. What is strategy – and does it matter? (Ontario: Thomson
International, 2000) second edition [ISBN 9781861523778], Chapter 2.
Barney, J.B. ‘Firm resources and sustained competitive advantage’, Journal of
Management 17(1) 1991, pp.99–120.
Eisenhardt, K.M. and J.A. Martin ‘Dynamic capabilities: what are they?’,
Strategic Management Journal 21 2000, pp.1105–121.
Hoskisson, R.E., M.A. Hitt, W.P. Wan and D. Yiu ‘Theory and research in
strategic management: swings of a pendulum’, Journal of Management
25(3) 1999, pp.417–56.
McGahan, A.M. and M.E. Porter ‘The emergence and sustainability of abnormal
profits’, Strategic Organization 1(1) 2003, pp.79–108.
Prahalad, C.K. and G. Hamel, ‘The core competence of the corporation’,
Harvard Business Review 68(3) 1990, pp.79–91.
Priem, R.L. and J.E. Butler ‘Is the resource based “view” a useful perspective
for strategic management research?’, Academy of Management Review 26(1)
2001, pp.22–40.
16.1.4 Works cited
Amit, R. and P.J.H. Shoemaker ‘Strategic assets and organisational rent’,
Strategic Management Journal 14 1993, pp.33–46.
Hamel, G. and C.K. Prahalad Competing for the future. (Harvard: Harvard
Business School Press (1996) [ISBN 9780875847160].
Kogut, B. and U. Zander ‘Knowledge of the firm, combinative capabilities, and
the replication of technology’, Organization Science, 3(3), 1992, pp.383–97.
Nelson, R. and S. Winter An evolutionary theory of economic change.
(Cambridge, MA: Belknap Press, 1982) (Boston, MA: Harvard University
Press, 1990) [ISBN 9780674272286].
Penrose, E. The theory of the growth of the firm. (Oxford: Oxford University
Press, 2009; first published 1959) [ISBN 9780199573844].
Rumelt, R.P ‘Towards a strategic theory of the enterprise’ in R. Lamb (ed.)
Competitive strategic management. (Englewood Cliffs: Prentice Hall, 1984)
[ISBN 9780131549722].
Schumpeter, J.A. The theory of economic development: an inquiry into profits,
capital, credit, interest, and the business cycle. (Cambridge, Mass.: Harvard
University Press, 1934).

132
Teece, D.J., G. Pisano and A. Shuen ‘Dynamic capabilities and strategic
management’, Strategic Management Journal 18 1997, pp.509–33.
16.2 Introduction
In recent years and in part as a reaction to the success of the Porter
framework discussed in Chapter 14, the discipline of business strategy has
developed a concern with matters internal to the firm. In the literature,
there have developed two views of competitive advantage.
1. The competitive positioning view. The basis of this approach is
that sustained superior firm performance requires effective product-
market positioning. The intellectual origins are with Porter, and
the variables one is concerned with in order to assess competitive
advantage include: market share, product features, cost position,
brand positioning, geographic scope and vertical integration.
2. The resource-based view. The basis of this approach is that
sustained superior performance requires unique resources and
capabilities internal to the firm. We discuss the intellectual origins
below. The variables one is concerned with to assess competitive
advantage differ and include: technological skills, teamwork capability,
business processes, leadership, innovation and organisation culture.
In parts of the literature, these are assessed as alternative ways of
doing strategy. However, as Figure 16.1 illustrates, they are potentially
complementary in that the process of strategy formulation could examine
both sets of variables.
Figure 16.1: Sources of competitive advantage
These ideas have deep roots back as far as Schumpeter’s notion of cycles
of creative destruction (1934); he put considerable emphasis on activities
such as technological change in developing economic growth. However,
the main early contributions come from Penrose (1959). She maintained
that firms can create economic value not due to mere possession of
resources, but due to effective and innovative management of resources.
Unused productive services are, for the enterprising firm, at the
same time a challenge to innovate, an incentive to expand, and
a source of competitive advantage. They facilitate the
introduction of new combinations of resources – innovation –
within the firm.
(Penrose, 1959, p.85; emphasis added)
She developed the idea that all firms have slack, or unused resources, that
offer value-creating opportunities if recognised and exploited by managers.
Resource-based view
Input markets
• People
• Technology
• Capital equipment
• Buildings
• Land
Factors of production Firm
Competitive positioning view
Products and services
Output markets
• Technology products
• Industrial products
• Consumer products
• Agricultural products
• Services

133
The idea was not initially taken up by strategy writers but Porter’s focus
on the appropriation of existing rents was increasingly seen as failing to
explain how rents were created unevenly across companies. In economics,
Nelson and Winter (1982) argued that organisations have repertoires of
creative routines that generate innovation and profit opportunities. Rumelt
(1984, p.561) noted that the strategic firm ‘is characterised by a bundle of
linked and idiosyncratic resources and resource conversion activities’. By
idiosyncratic he means that firms have different bundles of these attributes
and this might be a way of explaining differential performance.
16.2.1 The resource-based view
These ideas were developed within the strategy discipline by Barney
(1991) into the resource-based view of the firm.
For Barney, resources are the tangible and intangible assets that a firm
controls, which it can use both to conceive of and to implement its
strategies. They are of different types – they can be financial, physical,
human and organisational. He distinguishes capabilities – a subset of
the firm’s resources which are the assets that enable a firm to take full
advantage of the other resources it controls.
The essence of this approach is heterogeneity, the idea that apparently
similar firms may possess different bundles of resources. For heterogeneity
to persist, there must be immobility, meaning that resource differences
between firms may be long lasting. He also introduces the idea of path
dependence – the history of the firm matters to the accumulation of
resources. In the resource-based view, the firm is a portfolio of attributes,
not a chess piece to be moved around the industry board. One does not
look at marketing or financial attributes, but one looks inside the firm for
sources of competitive advantage. This is depicted in Figure 16.2.
Figure 16.2: The firm as a portfolio of attributes
There are a number of implications. The first is that compared to Porter,
the idea of an industry is relatively unimportant. The deployment
of resources may not follow industry boundaries. The second is that
competitive advantage is not seen as the outcome of a one-shot game to
achieve the optimal position. Rather, competitive advantages must be built
and success depends on the continuous renewal of advantages through
management activity.
Resources that are to sustain competitive advantage must be valuable,
scarce and difficult to imitate. Advantages persist due to barriers to
imitation and these barriers may be created by managerial action. His
definition is as follows.
1. Valuable − significant performance consequences (increases
revenues, reduces costs).
2. Scarce − not widely disseminated among competitors.
Organisational
MarketingCompetitive
Costs market
Vertical
integration
Strategic
group
Assets Revenues
Returns to
investors
Financial
structure
Products
Promotion
Pricing
Distribution
Systems
Efficiency
Technology
Quality
Structure
Leadership
Culture
Motivation
Operational Institutional
Financial
History
Governance
Reputation
Relationships

134
3. Difficult to imitate − not readily imitable by competitors; not
substitutable; causal ambiguity.
In analysis of the sources of competitive advantage he adds another
condition, namely that the firm must be organised to exploit its resources.
This, as we shall see, opens up the possibility that firms with identical
resources may be differentially competitive depending on whether they
are organised to exploit, and suggests an underlying dimension to resource
leverage that requires examination.
Valuable? Rare? Costly to
imitate?
Organised
to exploit?
COMPETITIVE IMPLICATIONS?
No Competitive disadvantage
Yes No Competitive parity
Yes Yes No Competitive advantage (temporary)
Yes Yes Yes Yes Competitive advantage (sustained)
Table 16.1: Relationship between resources and competitive advantage
Table 16.1 displays his approach. It requires an approach to resources that
explains why they might not be easy for competitors to copy or to imitate.
Barney deals with three barriers to resource imitation.
1. Causal ambiguity: By this he means that there may be barriers for
rivals in understanding the resource implications. Either rivals cannot
observe the resource, or they cannot replicate or reverse-engineer
it. This may be because of the social complexity of organisational
resources.
Examples: Organisational culture, systems, motivation, commitment.
2. Unique historical trajectory: By this he means that rivals cannot
replicate the historical sequence of events. It is essentially an argument
about the path-dependency of firm performance.
Examples: First-mover advantages such as location, raw materials.
3. Time compression diseconomies: This means that the resource
is inherently time-consuming to accumulate.
Examples: Reputation, knowledge, skills, relationships, experience.
The last point requires some analysis of the difference between resources
in terms of their imitability over time. He uses the idea of resource cycles
as follows.
• Fast-cycle resource: Diffuses quickly through a population of firms;
not a sustainable competitive advantage.
Examples: Web design; breakfast cereals; retail store layout; fashion
items.
• Medium-cycle resource: Diffuses more slowly through a
population of firms; sustainable in the short-run.
Examples: Total quality management (TQM) in manufacturing;
business process re-engineering.
• Slow-cycle resource: Diffuses very slowly through a population of
firms; sustainable as competitive advantage.
Examples: Microsoft’s operating system; Disney’s experience; legally
protectable intellectual property (IP).

135
16.3 Dynamic capabilities
Barney’s idea that firms with similar resources might be differentially
organised to exploit them led other researchers to question whether some
underlying resource mobilisation set of attributes might be examined. Put
another way, where do valuable, rare and inimitable (VRI) resources come
from?
Teece et al. (1997) and Eisenhardt and Martin have developed the
dynamic capabilities approach to analyse how VRI resources are created.
They define the idea of dynamic capabilities as:
… the firm’s ability to integrate, build and reconfigure
internal and external competence to address rapidly changing
environments.
(Teece et al, 1997)
Eisenhardt and Martin argue that capabilities themselves do not need to
be idiosyncratic:
… competitive advantage lies in the resource configurations
they create, not in the capabilities themselves.
(Eisenhardt and Martin, 2000)
Examples of capabilities include:
1. strategic decision-making
2. acquisitions and alliances
3. innovation
4. divestment
5. absorptive capacity (by this they mean the ability to absorb competitor
information).
16.4 Core competences
Hamel and Prahalad (1996) have developed a parallel idea in the notion
of core competences. These are organisational attributes that are:
• integral to the organisation’s success
• generating fundamental customer or cost benefit
• providing competitive differentiation
• learning-based accumulations of skill and experience
• vested in people
• supported by technology, processes and value.
They are clear that core competences are not:
• values or sets of wishes
• physical or financial assets
• individual skills
• patents or intellectual property rights
• products.
In fact, these items may be generated by the leverage of competences.
Competences provide access to markets and consumer benefits.
The application of the two key competences, singly or in combination,
are seen to generate the value proposition. The specific products are

136
almost incidental; they are vehicles for the application of the competences
to the value proposition. But the competence approach also sets a limit
on product development − specifically, if a product is proposed which
does not apply the competences, the implication is that it should not be
launched. In this view, one function of the strategy process is to test the
limits of the application of competences to product.
Activity 16.1
Go to the website of the Walt Disney Corporation.What do you think are the core
competences of this organisation?
16.5 Critique
This set of approaches has some differences but rests on the general
proposition that the sources of competitive advantage are internal to the
firm. Some have questioned whether anything original is being offered.
For an economist, this may merely be ‘a theory of rents based on resource
market imperfections’ (Amit and Schoemaker, 1993). Others see this as a
simple recapitulation of the central Chandler proposition that:
… what firms do better than markets is the sharing and
transfer of the knowledge of individuals and groups within an
organisation.
(Kogut and Zander, 1992, p.383)
Other, more practical criticisms concern:
• vagueness, how to falsify
• ex post analysis, not prediction
• what are the mechanisms precisely through which resources create
competitive advantage?
• how practically useful is the approach, particularly for new firms in
dynamic environments?
• what are the organisational correlates of effective resource
management?
All versions of the resource-based view (RBV) may be seen as an extension
of the Penrose tradition which in turn develops Chandler’s idea of the firm
as a bundle of capabilities. The managerial role is to identify and leverage
these capabilities to generate performance; this is similar to the implied
role in structural contingency theory. The RBV developed partly in reaction
to the Porter emphasis on external industry factors and firm homogeneity.
However, the value, rarity, inimitability and organisation (VRIO) approach
also adopts the Porter notion of sustained competitive advantage.
The dynamic capabilities model moves away from static analysis and
implies an extension to the managerial role into the development of firm
capabilities; it also identifies generic capabilities that may be transferable.
The competence approach tends towards the conclusion that industry does
not matter at all, since products flow from competence application.
However, in all of these approaches, ex ante identification of resources,
capabilities and competences is poorly theorised.

137
16.6 Strategy today
In the practice of strategy today the separation of conception as analysis
from execution as process is very rare. This means that industry analysis,
competence analysis and change management often need to be synergistic.
But, for consulting firms, it does not follow that clients will buy all three
from a single provider (many consulting firms now organise around
industries). In many business schools there are strategy faculties that are
focused on process or decision-making (sociology, psychology) and those
that do analysis (economics, game theory).
Formulation
Internal
• Mission
• Goals
• Objectives
Action
• Industry analysis
• Key success factors
• Competitive position
• Opportunities and threats
External
• Risk analysis
• Negotiation
• Strategic choice
Decision
• Resources and capabilities
• Functional area analysis
• Financial analysis
• Strengths and weaknesses
AnalysisGoals
• Values
• Purposes
Vision
Implementation
• Competitive advantage
• Strategic alternatives
Synthesis
• Structure
• Culture
• Processes
• Systems
• Deployments
DATA
Figure 16.3: Strategy as (rational?) process
Figure 16.3 attempts a summary of the strategy process. It implies a mix
of abstract analysis of opportunity with more qualitative assessment of
what can be implemented in the firm concerned. Synthesis of the external
analysis may involve compromise between the optimal and the possible.
Activity 16.2
Within the firm, who do you think should be involved in the strategy process depicted
in Figure 16.4?
16.7 Overview of the chapter
This chapter has examined the most prominent theoretical perspective
to emerge in the strategic management discipline in recent decades: the
resource-based view of the firm. The emergence of this re-focus on the
‘internal’ elements of company strategy has been placed in disciplinary
context. Major works of both scholarly (e.g. Barney, Eisenhardt) and
practitioner-oriented RBV authors (e.g. Hamel and Prahalad) have been
reviewed to provide a representative picture of the concerns, methods,
findings and debates of the RBV (and associated knowledge-based view)
theoretical perspectives. The chapter concluded with a brief discussion of
trends in strategic management practice.

138
• describe the resource-based view (RBV) of the firm and its implications
for strategy
• discuss the dynamic capabilities approach to strategy formation
• explain the concept of core competence and its use
• describe the idea of an integrated strategy process.
Critically evaluate the contribution of the resource-based view of the firm
to the discipline of strategic management. Illustrate your answer with
examples.

Chapter 17: Strategy and decision-making
139
Chapter 17: Strategy and decision-
making
• explain prescriptive and descriptive approaches to decision-making
within organisations
• discuss the three meanings of bounded rationality
• describe biases and heuristics
• outline Prospect theory and framing.
Bazerman, M. Judgment in managerial decision making. (New York: Wiley,
2002) fifth edition [ISBN 9780471398875], Chapter 2.
Bromiley, P. The behavioral foundations of strategic management. (Oxford,
Blackwell, 2005) [ISBN 9781405124706], Chapter 1.
Fenton-O’Creevy, M., N. Nicholson, E. Soane and P. Willman Traders: Risks,
decisions and management in financial markets. (Oxford: Oxford University
Press, 2005) [ISBN 9780199226450 pbk)].
Simon, H.A. Administrative behaviour. (New York: Macmillan, 1997; first
published 1947) [ISBN 9780684835822 (pbk)].
17.1.4 Works cited
Cyert, R.M., H.A. Simon and D.B. Trow ‘Observation of a business decision’,
Journal of Organisational Behaviour 29 1956, pp.237–43.
Fama, E.F. ‘Market efficiency, long-term returns, and behavioral finance’,
Journal of Financial Economics 49 1998, pp.283–306.
Feldman, M.S. and J.G. March ‘Information in organisations as signal and
symbol’, Administrative Science Quarterly 26(2) 1981, pp.171–86.
Gigerenzer, G. ‘Striking a blow for sanity in theories of rationality’ in Augier, M.
and J. March (eds) Models of a Man: Essays in Memory of Herbert A. Simon.
(Cambridge, MA: MIT Press, 2004) [ISBN 9780262012089].
Kahneman, D. Thinking, fast and slow. (London: Penguin, 2011)
[ISBN 9780141033570].
Kahneman, D. and A. Tversky ‘Prospect theory: An analysis of decision under
risk’, Econometrica 47 1979, pp.263–91.
17.2 Introduction
There are two literatures looking at decision-making within organisations:
1. rational and prescriptive – logical analysis of the decision task
and the use of deductive methods to derive the behaviour of rational
actors (e.g. expected utility theory in economics)
2. descriptive – empirical, often psychological, seeking general
principles to explain observed preferences and actions (e.g.
identification of heuristics and decision biases).

140
Empirical work in management has investigated processes of decision-
making in large organisations. The early work is particularly associated
with the Carnegie-Mellon school in general and Herbert Simon in
particular. Later work associated with Kahneman has been experimental.
Both have developed concepts to describe systematic variance from
rationality in decision-making. We will look at each but, first, let us clarify
the rational model from which they dissent.
Utility maximisation in economics suggests a decision process in which the
individual decision maker:
• thinks of all conceivable actions
• assesses all the consequences of each action
• derives a utility for each action, retrieved from the decision-maker’s
own preferences
• computes the probabilities of all outcomes
• chooses the action.
The central question for descriptive approaches is as follows: is this a
realistic description of how decisions are made or, if not, what percentage
or types of decision can be so characterised? The example used by Simon
himself is that of looking for a needle in a haystack. Does the actor
search until she finds a needle, or then keep searching until she finds the
brightest and sharpest needle? Simon’s answer involves two key concepts.
1. Satisficing behaviour. The actor searches until she finds a satisfactory
outcome, rather than searching for the optimum outcome.
2. Bounded rationality. The actor cannot know how much longer the
search for the optimum will take, and hence whether it is worth it or
not.
These ideas came from some key early studies in management theory.
Cyert, Simon and Trow (1956) and Simon (1947) found that:
1. Economic models appear to describe an approach to repetitive and
well-defined problems with pre-established options.
2. Long-term or strategic decisions of a non-repetitive sort appear to
generate highly unstructured search and decision processes.
3. Expected utility theory was a valid descriptive model for a category
of decisions but: ‘We should be sceptical in postulating for humans…
elaborate mechanisms for choosing among diverse needs.’ (Simon,
1955, p.137)
Feldman and March (1981) studied a range of organisational decisions
and found that:
1. Much information that is gathered and communicated has little
decision relevance.
2. Much information used to justify a decision is collected after the event.
3. Much information requested is collected then not used.
4. Regardless of information availability, more information is requested.
5. Complaints about lack of information coincide with relevant
information being ignored.
This is inconsistent with rational organisational decision-making but
not inconsistent with individual rationality as described in game theory
or signalling theory – rational self-interest aggregates to an inefficient
outcome.

141
Simon’s ideas about bounded rationality have been very influential, but in
the modern literature the term is used in at least three ways.
1. Rationality is limited by processing and informational requirements.
There are sets of decisions that involve such complexity in both that
rationality is affected. This is Simon’s original idea. The parameters of
the decision, particularly complexity, are key.
2. Modern economists often use the term to refer to information
asymmetry. That is, rational actors may make suboptimal decisions
because they lack relevant information and the search costs for that
information are very high. The parameters of information distribution
are key.
3. A third use of the term follows, over a number of years, from the work
of Kahneman and Tversky. It is well summarised in Bazerman (2002).
Rationality is systematically impaired by cognitive factors which cause
patterned deviations from optimum. The parameters of the decision-
maker are key.
Thinking is very hard and the mind tries to avoid it when possible
(Kahneman, 2011).
Their approach is as follows.
• It is not so much that one’s mind is lazy as it is extremely busy… think
of all the tasks the mind must constantly perform/monitor − adjusting
the heart rate, breathing and keeping muscles flexed, etc.
• Our mind copes with this amazing amount of demand by ‘automating’
as much as possible, for example, information processing through
automation/routines.
• The automation allows us to concentrate on one thing while
performing another – we can multi-task.
• To accomplish this, the mind has evolved shortcuts or rules-of-
thumb to help it deal with complexity.
Heuristics are thus shortcuts used to help make judgements and
decisions in complex situations with minimal effort. Most of the time
heuristics work well and are necessary for the mind to work; for
Gigerenzer (2004) heuristics are smart and are often the optimal response
to situations. He uses the term ‘ecological rationality’; for example, most
people estimate they are ‘better than average’ on a variety of indicators.
This irrational (if underlying) distribution is normal but not if negatively
skewed. If the distribution of driving ability is normal, the majority cannot
be above the average; if, however, there are a small number of very bad
drivers, many can be.
However, these rules-of-thumb can lead to systematic bias/errors – often
suboptimal (Tversky and Kahneman, 1979). Heuristics are not biases but
can lead to biases; and biases are not errors – error is random, biases are
systematic deviations from rationality. We give many examples below but
here is an indicative one: there is a widespread tendency from empirical
work for people to overestimate the frequency of high-impact events – for
example, aeroplane crashes – since they estimate frequencies based on
consequences.
Activity 17.1
In this subject guide, which three-letter word ending is most common: -ing or -n- (-
meaning any letter)?

142
17.3 Efficient markets
We illustrate the content of theories based on this approach by examining
competing explanations for market behaviour in finance. The main theory
is the efficient markets hypothesis. There are three different forms of the
efficient market hypothesis (Fama, 1998).
• The weak form states that present prices reflect all information
contained in the record of past prices. In other words, past prices are
no guide to the future.
• The semi-strong form states that current prices incorporate not only all
information from past prices but also all other published information.
• The strong form states that current prices incorporate all information
that could be acquired by a painstaking fundamental analysis of the
asset and economic circumstances.
Each has different assumptions about rationality. The strong form makes
very strong assumptions about the behaviour of market actors and implies
that there should be very few profit opportunities in markets since they are
rapidly traded away.
The discipline of behavioural finance is based on observations of market
anomalies which appear to contradict the efficient markets hypothesis.
(For a review, see Fenton-O’Creevy et al., 2005, pp.28–51). For example,
anomalies observed at the level of the market – noise (too much trading),
stock picking and selling a falling stock – are seen as evidence of a
cognitive bias to explain the pattern of behaviour underlying anomaly.
The three biases relevant to the three mentioned anomalies are action
bias (preferring action to inaction), retrievability bias and loss aversion.
There is no ‘theory of irrationality’ explaining the incidence or frequency
of anomalies and therefore nothing to match or disprove the efficient
markets hypothesis.
We take one bias − loss aversion − to illustrate Kahneman’s work since
it is central to his winning the Nobel Prize for his work. Loss aversion
is central to ‘Prospect theory’ which is illustrated in Figure 17.1. Loss
aversion is defined as engaging in high-risk behaviour to avoid the
experience of loss relative to a reference point. Figure 17.1 illustrates
that when we deal with gains, we tend to be risk averse (as predicted
by expected utility theory) but when we deal with losses, we tend to be
risk seeking; that is, we will take bigger risks to eradicate a loss. This
is captured by the steeper curve in losses below R; we experience more
subjective disutility than the objective size of the loss.

143
Figure 17.1: Prospect theory: a hypothetical value function
Source: Kahneman and Tversky, 1979. © The Econometric Society. Reproduced by
kind permission.
Prospect theory also distinguishes between probabilities and the
weight those probabilities have in the decision-making process. This is
illustrated in Figure 17.2.
Recall the aeroplane crash example above. The decision weight line
illustrates that we would overestimate the chance of the airplane crashing
but underestimate the chances of a car crash on the way to the airport.
Note: ‘weight’ − impact of (high/low probability) events
Decision
weight
Normative line
Probability
Weight
Figure 17.2: Decision weights versus probability
This is experimental work often with student subjects but there is empirical
work in financial markets which illustrates decision biases. Fenton-
O’Creevy et al. (2005) tested traders for the bias of illusion of control, for
example, an unrealistic belief that we can influence events. They presented
traders with a random walk line and suggested three inoperative keys
on the keyboard could influence it (see Figure 17.3). Traders with a high
illusion of control showed less-effective performance in terms of:
• risk management
• analysis
risk-seeking
risk-averse
£
Perceived value
(Utility)
R

144
• contribution to desk profits
• own remuneration.
At a conservative estimate the difference in annual remuneration between
a trader with a high illusion of control (in the top 18 per cent) and a trader
with an average illusion of control was about £100,000.
Figure 17.3: Correlation between traders’ illusion of control over experiment and
their contribution to profits
Source: Fenton-O’Creevy et al., 2005.
17.4 The decision process
The following four tables show how biases can affect the decision process.
A simple linear process of information gathering, processing, decision
taking and outcome assessment is used as a framework to show how
biases identified in Bazerman (2002) can affect each stage. Key points to
note are:
• Some biases can affect several stages of the process.
• Some biases are individual and cognitive and some consist of pressures
on decisions that are social or normative.
Illusion of control
Contributiontodesk’sprofits
0.00 25.00 50.00 75.00 100.00
0.00
25.00
50.00
75.00
100.00

145
Cognitive bias Consequence of bias
Retrievability and
availability bias
Selective attention given to what stands out, or springs
easily to mind
Base-rate insensitivity Focus is on objective not relative frequency
Failure to apply
sampling theory to
small numbers
True likelihoods are miscalculated
Conjunction fallacy Unconnected information is falsely assumed to be linked
Framing and order
effects
Different weights are assigned to first versus last in a
sequence
Subjective frequency
estimates
Infrequent events are overestimated, frequent events
underestimated
Confirmation bias Search is biased towards confirming rather than
disconfirming evidence
Table 17.1: Influence of cognitive biases on information gathering
Loss aversion not risk aversion Lottery behaviour occurs - gambling on
long odds
Miscalculated probabilities Only hits not misses are scrutinised, or
vice versa
Gamblers’ fallacy Connections are mistakenly perceived
between unconnected events
Over-confidence and self esteem Optimism is greater than objective
chances merit
Ego-involvement Too little or too much emotional
attachment is given to events or
outcomes
Stress Load, uncertainty, conflict affect ability to
think and act clearly
Framing of targets Behaviour changes according to whether
a target is conceived of as ‘avoid worst
case’ or ‘achieve goal’
Insufficient anchoring adjustment Readjustment to target after feedback is
insufficient
Representativeness bias Isolated events or information are
assumed to be representative
Table 17.2: Influence of cognitive biases on information processing

146
Asymmetries of loss
and gain
Losses are chased more than gains
Endowment effects What you have to sell is undervalued relative to what you
buy
Social norms The risk or decision profiles of the local culture are followed
Groupthink Intragroup momentum governs a decision, and censors
dissent
Herding Instead of making rational choices, we watch what others do
Incentives Risk-reward outcomes are distorted by personal payoff
system
Impression
management
More important to look good than do good
Competitive pressures It becomes more important to win than to achieve
Table 17.3: Influence of cognitive biases on decision taking
Hindsight bias History is rewritten; “I knew this would happen”
Regression to the
mean
Random variations are perceived as systemically caused
Rationalisation of
outcomes
Failures are re-evaluated as benefits
Illusions of control It is believed uncontrollable outcomes can be controlled
Escalating commitment Good money is thrown after bad; motivated by sunk costs
Failure reactions Learning is for future avoidance rather than analytical or
constructive insight
Attribution errors Errors are over-attributed to will and personality, and too
little to situation and chance
Table 17.4: Influence of cognitive biases on reactions to decision outcomes
This chapter traced the evolution of behavioural decision theories from
their origins in the 1950s to the present day. Behavioural theories are
normally based on:
i. a concept of a ‘good’ or ‘rational’ approach to decision-making
ii. empirical evidence which shows that people do not follow such an
approach
iii. a theoretical account of why such departures from rationality occur,
and, sometimes
iv. some suggestions as to how to help people make more rational
decisions.
In this chapter we centred mostly on the celebrated ‘heuristics and biases’
tradition of Kahnemann and Tversky, showing how the approach that
these authors developed can shed light on both economic behaviour in
financial markets and managerial decision-making.

147
• explain prescriptive and descriptive approaches to decision-making
within organisations
• discuss the three meanings of bounded rationality
• describe biases and heuristics
• outline Prospect theory and framing.
What is a rational decision? Describe some of the barriers to rational
choice in organisations and how they can be overcome.

Notes
148

Chapter 18:The origins of marketing
149
Chapter 18: The origins of marketing
• explain what is meant by the ‘marketing framework’
• discuss the history of marketing theory and the marketing business
orientation
• describe how marketing fits into the traditional economic model of
perfect competition
• outline how marketing makes use of different theories used in other
academic disciplines.
Willman, Theme 6.
Kotler, P. and G. Armstrong Principles of marketing. (Harlow: Pearson Education
Ltd, 2013) sixth European edition [ISBN 9780273742975] Chapter 1.
Brassington, F. and S. Pettitt Essentials of marketing. (Harlow: Prentice Hall,
2012) third edition [ISBN 9780273727644].
Nevett, T. and R. Fullerton Historical perspectives in marketing. (Toronto:
Lexington Books, 1988) [ISBN 0669169684].
Pindyck, R. and D. Rubinfeld Microeconomics. (Upper Saddle River, NJ:
Pearson/Prentice Hall, 2012) eighth edition [ISBN 9780133041705].
18.2 Introduction
Before we can start discussing marketing theories and concepts, it is
useful to understand that marketing was (and to a large extent still is) a
composite of a number of other academic disciplines. It is also important
to understand where marketing originated from and what its intellectual
foundations are.
In this chapter we will examine the emergence of marketing as a
management discipline. In particular, we will examine how marketing
fits into the traditional economic model of perfect competition. We shall
see that marketing divorced itself from economics in the mid-to-late
1960s with the emergence of modern founders such as Joseph Kotler and
Theodore Levitt (who were themselves former economists). This will be
followed by a discussion of the four main historical business orientations
(for example, production, product, selling and marketing) and how
marketing fits into this identification as well. The chapter will conclude
with an examination of marketing problems and how marketing students
can draw upon different academic disciplines such as psychology as well
as economics to solve them.

150
18.3 Definitions and a brief introduction to the history
of marketing as a distinct ‘discipline’ of study
Let us begin with three definitions of marketing and then discuss the
implications that those definitions have in relation to traditional economic
theory. After comparing marketing to economics we will go on to trace
the history of marketing as an independent academic discipline within the
field of management.
There are many definitions of marketing. Here we present three of the
most widely used versions from the inception of marketing to the present.
1. Marketing consists of those activities involved in the flow of goods
and services from the point of production to the point of consumption
(American Marketing Association (AMA), 1938).
2. Marketing is the process of planning and executing the conception,
pricing, promotion and distribution of ideas, goods and services to
create exchange and satisfy individual and organisational objectives
(American Marketing Association, 1985).
3. Marketing is the management process that identifies, anticipates
and supplies customer requirements efficiently and profitably (UK
Chartered Institute of Marketing, 2003).
Activity 18.1
Here is a question to ponder: what substantial differences exist between the first formal
definition of marketing, the AMA’s 1938 definition, and the one the AMA provided nearly
50 years later in 1985? What explains the changes, if any, in the definition?
Looking at the two most recent definitions of marketing one sees that they
agree on the following points.
• Marketing is a management activity and not strictly a ‘market’ process
(though it depends on market signals).
• Marketing is about giving customers/buyers/users what they need and
want.
• In the AMA version, marketing is about exchanges (for example, of
ideas, goods and services).
• The AMA definition also describes the ways in which marketing
can stimulate exchanges (for example, through conception, pricing,
promotion and distribution).
Further information about these definitions can be found in Brassington
and Pettitt (2012).
18.4 Marketing and economic theory
Why should we compare marketing to economics, you may ask? The
reason is that marketing was originally embedded in economics courses
and programmes. If one thinks of the conventional starting point in neo-
classical economic theory, however, there would be no pressing need to
study something called marketing. Why?
Well, let us begin with some key assumptions of the competitive
framework, starting with the firm and the products they sell.
First, we have many small firms x (xi, i=1…n), each taking a price as
given. The demand curve facing every firm is perfectly elastic. This

151
means that individual decisions concerning production have no effect
on the market price for the good in question. In other words, they are
homogeneous firms that accept what the market gives them. They have no
power to shape their market environment, at least over pricing, which is a
very big component of what marketing is.
Second, we have a homogenous product (either real or perceived that way
by consumers). There is no scope for branding your product differently
from others. The decision for the firm amounts only to produce and price
(P) at the point where marginal cost (MC) equals marginal revenue (MR)
(e.g. MC = MR = P).
The total supply in the market is merely the summation of the individual
supply curves of each firm. Graphically it would look something like the
following diagram:
P
AC
Q
C
Supply = M
p=MR=Demand
Figure 18.1: Price and demand conditions facing an individual firm (x)
So far we have just sketched out (in a very fast-and-loose fashion) the
basic behaviour of a perfectly competitive firm in a perfectly competitive
market. At this stage, however, it may be useful to clarify exactly what we
mean by a perfectly competitive market and how this relates to the
marketing framework.
More rigorously, the theory of perfect competition rests on the following
four assumptions.
1. Price taking: Both consumers and firms do not affect the price – or
stated another way, both consumers and producers believe (correctly)
that their decisions will not affect the price. The ‘law of one price’
prevails.
2. Product homogeneity: Products are undifferentiated, therefore
consumers consider only price when choosing where to buy from. This
means that any firm that tries to raise its price will lose all sales.
3. Perfect information: Consumers have perfect information about
their preferences, their income levels, the prices they face and the
quality of the goods they purchase. Likewise, firms have perfect
information about costs, prices and technology. This means that there
is little scope for promotion policies as all information is known.
4. Perfect mobility of resources: Firms can freely enter an industry
if they are making a profit, or exit it if losing money. This means that
firms have few extra resources to devote to marketing efforts. Thus, in
a perfectly competitive environment, the following three key points, or
‘theorems’, emerge for marketing as a discipline in its own right.
Theorem 1: Because of the law of ‘one price’, in a competitive
market, price is not a strategic marketing tool for the individual
firm.

152
Theorem 2: Equally, price and product development are not
important marketing tools when a firm operates in an industry
with undifferentiated products.
Theorem 3: With perfect information, no gains can be had from
informative promotion or formal advertising.
There is an obvious symmetry here, in that these three theorems fall out of
the first three assumptions of competitive markets.
The answer, therefore, to the question that started off this sub-section
is: ‘marketing does not fit into traditional economic theory in the sense
that the perfectly competitive view of markets seems to rule out most
marketing activities’.
Where it does fit, it only fits in rather tangentially, in that the most
important strategic tools − pricing and promotion − become irrelevant
marketing channels when markets approach perfect competition.
18.5 Where does economic theory leave us?
Given that marketing exists and given that firms devote huge amounts
of money to the marketing of their goods and services, we need to ask
ourselves the following: ‘What theory or economic model is consistent with
what firms do in practice?’
This question will be explored when we break the competitive assumptions
of neo-classical economic theory and examine a world of economics which
contains heterogeneous firms and consumers, differentiated products,
imperfect competition and information, uncertainty, risk or social
networks, and other non-economic social considerations. In other words, a
world that more closely resembles the one we live in.
Indeed, by breaking these competitive assumptions, one would be able to
answer questions such as: why, in 1995, did management gurus Treacy
and Wiersema secretly purchase 50,000 copies of their own business
strategy book The discipline of market leaders from bookshops across the
USA? (Hint: ask yourself what is an important driver of book sales?)
18.6 Marketing as ‘academic discipline’
You may wonder why a history of marketing is of interest in the context
of more recent developments. Well, to paraphrase Joseph Schumpeter
(1883–1950), in order to understand the world around you and be a well-
grounded social scientist, one needs a command of four disciplines – that
is, economics, statistics, maths and history. However, if forced to choose
one, Schumpeter always claimed he would have chosen history.
A proper historical account of marketing would begin with early capitalism
and sociological theories of the growth of consumerist culture. However,
that is a bit beyond the scope of this guide. Instead, we will briefly trace
the growth and emergence of the so-called ‘marketing framework’, which
began in the 1900s when marketing began to divorce itself from its
founding discipline of economics. We will then go on to show why some
marketers argue that the marketing framework is the most ‘advanced’ of
all business orientations.
The development of marketing thought can be divided into four historical
eras.
First era: Classical school (1900–50): These theories focused
on aggregate market behaviour and were concentrated on the use

153
of traditional economics and sociology to understand market-driven
phenomena.
Second era: Managerial marketing school (1950–75): This era
began in marketing departments within the newly formed managerial or
business schools, which focused their attention on individual behaviour, but
continued their reliance on borrowing techniques from other social sciences.
Third era: Behavioural marketing school (1965–1980): These
schools have borrowed from different branches, mostly psychology,
in an effort to gain even greater insight into individual consumer and
Fourth era: Adaptive/strategic marketing school (1980–
1995): This school returned to a more economic focus. It was strongly
influenced by Michael Porter and his five-forces model and the paradigm
of competitive advantage. Advances in economic strategy and game theory
also influenced the growth of the strategic marketing school.
It is interesting to note that most marketing courses only appeared in
university course curriculums in the late 1960s and early 1970s. A good,
and more detailed, description of these eras can be found in Nevett and
Fullerton (1988).
18.7 The influence of other academic disciplines and
marketing
As can been seen above, marketing itself is not (and has never been) a
unitary theoretical discipline. Rather, it is a framework that draws from
many different academic disciplines. Although its roots are in industrial
economics, it is actually a composite of three major academic disciplines:
economics, psychology and management. Each theoretical approach
has its specific contribution to areas of marketing, which are summarised
in the table below:
Academic discipline Area of marketing relevance
Economics Price theory and strategy
Game theory
Psychology Consumer preferences and
behaviour
Advertising
Management General strategy
Demand analysis
18.8 Types of marketing problems
Real-world marketing problems involve all three disciplines to varying
degrees and proportions. A marketing practitioner has to decide which
academic discipline is most relevant to the problem at hand. Marketing
problems can be essentially divided into four groups.
1. Operational marketing problems involve working with existing
opportunities, for example, by targeting the product to a specific
segment of consumers.
2. Analytical marketing problems are related to the market
structure in which a firm operates, and its effects on the firm’s
marketing approach.

154
3. Normative marketing problems are those which concern
themselves with how things ‘should be’. An example of this is the
emergence of corporate social responsibility and ethical marketing (‘no
logo’ movement).
4. Strategic marketing problems involve evaluating the needs of
customers and evaluating how the company can provide a solution to
these needs.
Each problem requires a different set of academic approaches. It takes
time to develop the requisite skills as a marketing analyst or practitioner
to know when to use which approach to solve a given problem. In some
cases, even defining what the problem is requires experience and subtle
knowledge of the problem at hand.
18.9 The triumph of marketing?
Having described the evolution of marketing theory and its evolution as
a discipline of management study, we will now look at a brief account of
the emergence of the current ‘marketing framework’, which has come to
dominate the way in which certain industries and markets operate.
There are four main business orientations, each of which has emerged as a
response to evolutions in the marketplace. If we were to ask the question:
‘What kind of a firm do you (have you) work[ed] for?’ the answer is likely
to be found in one of these four orientations:
• Production: Here the focus is on producing more, selling high
volumes, controlling costs and production efficiency. The firm which
pioneered this orientation was Ford in the early 1900s, with its
adoption of assembly line manufacturing and a standardised product
− the Model T − which was famously available in any colour ‘as long
as it’s black’! (See the mini-case activity below.)
• Product: This orientation moves away from standardised products
and focuses on improving quality. The assumption is that customers
want a better-quality version of the same thing and are prepared to
pay a premium for a differentiated product. This approach was first
adopted by General Motors in the 1930s, which gained market share
from Ford by offering customers a diversified product line. (See the
mini-case activity below.)
• Selling: The selling orientation, as the name suggests, focuses on
aggressive sales and promotion to sell whatever the organisation wants
to make. Here the seller’s needs come first, and products are ‘pushed’
under the assumption that if the price is low enough, customers will
buy the product whether they like it or not.
Examples of this orientation include firms that use door-to-door salesmen
to sell encyclopedias or vacuum cleaners. (This orientation is also nicely
portrayed in the 1988 Hollywood movie Tin Men and a decade later in
Boiler Room (1999), which depicts financial industry salesmen trying to
convince prospective investors to buy stock over the phone.)
• Marketing: The marketing orientation is the most advanced
orientation according to marketing founders such as Phillip Kotler.
They feel this way because marketing, unlike other orientations,
focuses on the end user by first defining customer needs and then
developing offerings/products/services that deliver what the customer
wants. In this approach, customers and their needs come first. Can you
think of a company that uses this orientation?

155
Activity 18.2
Why might customers have preferred to pay more for GM cars?
18.10 Looking ahead: the marketing framework
Let us end this chapter on a rather philosophical note. What is the ultimate
aim of marketing or of any form of production? The ultimate aim of
production is not the production of goods and services, nor the satisfaction
of a narrow set of consumer preferences, but rather ‘the production of free
human beings associated with one another in terms of equality’. This was
Jeremy Bentham’s (1743–1832) definition. We mention this in passing
because a group of marketing scholars and practitioners who believe in
something similar, which they call ‘social or ethical marketing’, and this is
Mini-case activity
Henry Ford versus Alfred Sloan: A contrast of business orientations
Before Henry Ford (1863–1947) first started to produce automobiles in 1905, they were
very much a luxury item. Ford’s dream was to democratise car ownership, by making cars
affordable.To achieve this ambition, his big innovation was to create a simple car, produced
in a streamlined production process. Ford´s pioneering vision was to regiment the production
process. He placed an emphasis on achieving productivity improvements and leveraging
economies of scale.The gains made were substantial: in 1913 it took 12 hours to manufacture
a Model T car, but by the following year this had been reduced to a mere 96 minutes thanks to
the introduction of the moving assembly line.
This increase in productivity allowed Ford to reduce the price of a car from over $800 in 1908
to under $450 in 1914.This allowed a much wider segment of the population to purchase
a car, radically changing American society and business. Production volumes also increased
dramatically in that period, from just over 10,000 cars in 1908 to over 730,000 in 1916 (when
their price fell to $360). He also had a radical social agenda. In 1914, when the average weekly
wage was around $11 a week, he introduced a $5 wage for an eight-hour day for his workers.
This not only motivated his workers, but also put automobiles within their economic reach.
His approach is characteristic of the production orientation, with a strong focus on efficient
production of a simple, optimised product. By the 1920s Ford was by far the leading car
manufacturer in America, but it was soon to be outdone by its rival General Motors (GM). How
did this come about?
When Alfred Sloan (1875–1966) became head of GM in 1925, he felt that there was a need for
a new development in the car market, which was suffering from saturation and technological
obsolescence. His solution to this problem was to introduce the concept of planned
obsolescence and an emphasis on a diverse product range and product styling, exemplified
by annual model facelifts. His assumption was that customers would become dissatisfied with
their ‘old’ car and would want to trade up to a newer and more expensive model before their
current cars had reached the end of their useful life.This tapped into the ebullient mood of
the 1920s boom years, and customers jumped on the possibility of differentiating themselves
through their car.
By 1928 Ford had lost its position as market leader, and by 1936 GM had a market share of
43 per cent of the US market, while Ford could only claim only 22 per cent. GM retained its
leadership until 1986. By allowing its customers to choose from a wide variety of models,
and emphasising design rather than engineering, GM was one of the pioneers of product
orientation.

156
one of their ultimate aims. They believe the marketing orientation, with its
focus on the end user and on solving problems for people, can achieve a
better society.
Modern definitions of marketing identify it as a management process that
involves the identification and anticipation of customer requirements. The
development of marketing can be divided into four eras. When marketing
became a widespread practice, at the start of the twentieth century, the
main focus was on aggregate market behaviour. In the 1950s, the focus
shifted towards individual customer behaviour. In the 1960s psychology
was added to the traditional social scientific ‘tool box’ in an attempt to
gain greater insight into individual consumer behaviour and into the
behavioural decisions of organisations. The focus of later theories returned
to the aggregate level and the paradigm of competitive advantage as well
as the strategic decision-making of firms.
Most businesses can be classified into four main business orientations
which evolved in response to changes in technology and society. These
were: 1) production, which focuses on production efficiency and high
volumes; 2) product, which provides a wider choice to the customer; 3)
selling, where aggressive sales techniques are used to ‘push’ the product to
the client; and 4) marketing, where customer needs are defined before a
product which can satisfy the needs is produced.
As we saw, according to the traditional model of perfect competition,
marketing should not exist (or at least, most marketing functions such as
pricing and promotion would have no real effects). Indeed, it follows from
the assumptions of the model that due to the absence of differentiated
products, the firm cannot employ price or promotion as a strategic tool.
It thus becomes clear that it is more interesting to examine marketing
under a different economic assumption, for example, models of imperfect
competition, which are not as restrictive as the neo-classical theory of
perfect competition.
Marketing is not in itself a theoretical dicipline; rather, it draws on tools
developed in a variety of other disciplines, such as economics, psychology
and management, to solve various marketing problems. These problems
can be divided into those which deal with the company’s existing
opportunities; those which relate to the market environment in which the
firm operates; those which influence the firm’s overall image; and, finally,
those which are concerned with identifying a strategy for the future.
Marketing theory approaches, like marketing itself, have to span both
the level of individual behaviour, which tends to be most informed by
economics and psychology, and aggregate behaviour and organisational
relationships where sociological and again economic approaches provide
much of the initial theoretical background. On top of this, much of the
aggregate work also relies to a considerable extent on advanced statistical
techniques.

157
• explain what is meant by the ‘marketing framework’
• discuss the history of marketing theory and the marketing business
orientation
• describe how marketing fits into the traditional economic model of
perfect competition
• outline how marketing makes use of different theories used in other
academic disciplines.
Describe, with an example from a specific company, the main elements of
the marketing plan.

Notes
158

Chapter 19:The origins of marketing − the development of the practice
159
Chapter 19: The origins of marketing −
the development of the practice
• describe the main elements of marketing
• discuss their integration into a ‘marketing strategy’
• outline the key elements of branding and advertising.
Willman, Theme 6.
Kotler, P. and G. Armstrong Principles of marketing. (Harlow: Pearson Education
Ltd, 2013) sixth European edition [ISBN 9780273742975] Chapter 1.
Weitz, B. and R. Wensley Handbook of marketing. (London, Sage, 2002)
[ISBN 9780761956822].
19.1.4 Works cited
Abernathy, W.J. The productivity dilemma. (Baltimore: Johns Hopkins, 1978)
[ISBN 9780801820816].
Dorfman, R., P.O. Steiner ‘Optimal advertising and optimal quality’, The
American Economic Review 44(5) 1954, pp.826–36.
Drucker, P.F. The practice of management. (New York: Harper and Rowe, 1954).
Holt, D. and D. Cameron Cultural strategy. (Oxford: Oxford University Press,
2010) [ISBN 9780199587407 (hbk)].
Ofir, C. and R.S. Winer ‘Pricing: economic and behavioural models’ in Weitz,
B. and R. Wensley Handbook of marketing. (London: Sage, 2002)
[ISBN 9780761956822], pp.267–81.
Pate, R. Adman: Morris Hite’s methods for winning the ad game. (Dallas, TX:
E-Heart Press, 1988) [ISBN 9780935014129].
Stewart, D.W. and M.A. Kamins ‘Marketing communications’ in Weitz,
B. and R. Wensley Handbook of marketing. (London: Sage, 2002)
[ISBN 9780761956822], pp.282–309.
Webster, F.E. ‘The role of marketing and the firm’ in Weitz, B. and R. Wensley
Handbook of marketing. (London: Sage, 2002) [ISBN 9780761956822],
pp.66–84.
19.2 Introduction
As Webster puts it:
Marketing exists both within the firm and outside it. It is
both a set of organisational management activities and a set
of institutional actors and functions within the marketplace,
external to the firm, in which the firm participates.
(Webster, 2002, p.67)
In this chapter, we will focus on the activities of marketing within the firm.
This is rather more than looking at the marketing department or function.

160
From its humble origins in concerns about distributional efficiency, the
academic discipline of marketing generated somewhat imperial ambitions,
most notably in the idea of the ‘marketing concept’ – seeing the whole
firm from the customer perspective. This was most notably articulated by
Drucker, who argued:
1. the sole purpose of the business is to create a customer
2. the customer’s view of what she is buying is more important than the
firm’s view of what they are making
3. all firms are only about marketing and innovation
4. marketing is much more than sales
5. marketing is the whole business, seen by the customer.
(Drucker, 1954, p.39; see also Webster, 2002; p.71)
This approach sees marketing as strategy, and we will use the elements of
a marketing strategy to organise the chapter. In the following sections, we
will focus on what managers do when they seek to manage markets, under
the conventional headings of product (including market segmentation),
price, promotion (including branding and advertising) and place (channels
and distribution).
19.3 Product1
The most important decision an organisation makes is what products
to offer and in which markets to offer them. The decision commits the
organisation to particular customers, to the use of particular technologies
and to engagement with specific competitors. In marketing, a product is
defined not as a physical item but as the total package of attributes the
customer gets when she or he buys the product (Kotler and Armstrong,
2004). It may embrace things such as packaging, after-sales service and
perhaps ongoing availability. Here are some illustrations.
• A Rolex and a Swatch are both instruments for telling the time, but
they are very different products. A Rolex is both a status symbol and a
piece of jewellery.
• Many car companies advertise their products with warranties of up to
seven years and free servicing. The presumption for both is that the
company selling the car will provide after-sales service.
• Apple sells a variety of devices fitted with iTunes software. The buyer
assumes forward compatibility – that the software will allow stored
music to be transferred to other devices, and that Apple will maintain
other activities such as iStore.
There is an important time dimension to products. They are seen to have
‘life cycles’ of growth, maturity and declines, as depicted in Figure 19.1.
These have implications for how the product is distributed, advertised and
priced. The length of a life cycle is an empirical question, but the cycle
in any given instance is a guide to the process of innovation and new
product development. If the firm wishes to have non-volatile sales revenue
it will innovate products to have some growing, some mature and some
declining products. Conversely, it will not wish to launch new products too
frequently since this will affect the sales revenues of more mature ones.
1
The term ‘product’ here
is used to apply both to
physical products and to
services.

161
Figure 19.1: The product life cycle
Activity 19.1
Apply the product life cycle curve to the Apple iPod.What will happen to Apple’s other
products during ‘decline’?
19.4 Markets
Marketing does not define a market in the same way as economics. For
economists, markets are a space where buyers and sellers meet. For
marketing, the emphasis is almost wholly on the market as a pool of
demand. Some of this demand is satisfied by the firm (market share) and
some is market opportunity (latent demand).
Markets are divided into segments in order to be targeted. A segment is
a set of actual or potential customers who are homogeneous with respect
to the product. Defining market segments creates the framework for a
marketing strategy. The main segmentation variables are as follows.
• Demography. This relies on variables such as income, age, gender,
ethnicity and educational background as explanatory variables
for tastes, buying behaviour or consumption patterns. However,
marketers do not only apply the term to segmentation of consumer
markets, they also refer to the demographics of firms, where the
buyer is another business. Here the variables are primarily size and
industry; for example, in management consulting, industry segments
(termed ‘vertical’ segments) are very important since industry-specific
knowledge is seen as an important part of the consulting process.
• Geography. This is also used to segment both consumer and
business markets. The key variables here are geographic differences
in product preference, market potential, trade regulations and
competition. However, geographic segmentation may emerge from
limits to the economical shipping distance of a product, or from the
fact that customers want the product or service to be locally available.
An example of the last point is the location decisions for shops and
Salesvolume
Time
Development
Introduction
Growth
Maturity
Decline

162
restaurants which are often calculated in terms of customer travel
times.
• Psychographic variables. These typologies segment the market
in terms of an individual’s lifestyle and attitudes towards self, family,
home and peer-group identity. Some typologies may echo demography
– such as categories such as ‘baby boomers’ or the ‘grey’ market. Others
relate to lifestyle choices – such as ‘couch potatoes’ or ‘exercise freaks’.
A very important distinction in the food market concerns those who
work (whose time is presumed to be limited) who will prefer prepared
foods versus those who prefer to buy ingredients and spend time
cooking. Therefore prepared meals tend to be priced at a substantial
premium over the cost of their ingredients.
• Product use. The purpose for which a product is purchased
is important for marketing, hence knowledge about the buyer’s
purpose is important. For example, the same item of crockery may
be purchased by an individual for home use, by a restaurant for
commercial purposes, or as a wedding gift.
Defining the combination of product and segment is important and the
firm needs to ask the following questions.
• Where does the product have the most value? Market entry and
development efforts should focus on the segments that value the
product most highly and will pay the most.
• What is the growth potential? This relates to the size of the segment
and the length of the product life cycle as discussed above.
• What resources do we need to commit? This relates to material we
covered in Chapter 12. The decision to enter a market segment with a
specific product should have a positive net present value.
• What is the competition? New market entrants should be differentiated
in some way in the customers’ minds. We may think of the frameworks
discussed in Chapter 13 as ways of analysing this issue.
• Does the opportunity fit the company? There may be opportunities in
products and segments which are in themselves profitable but have
damaging wider implications. Here are two examples. In the US car
industry in the 1970s, companies were aware that consumers wanted
smaller, more fuel-efficient cars but did not develop them because they
thought it would cause a drop in the sales of full-size, more profitable
models (cannibalisation). They only did so when Japanese imports
captured market share (Abernathy, 1978). In luxury goods industries,
such as cars, watches and diamonds, products are rationed and
consumer ‘queues’ exist because the value of the product depends on
its scarcity and exclusivity; expanding output to new markets would
damage the ‘brand’.
19.5 Pricing
In economics, price is set by the balance between supply and demand.
However, marketing emphasises the ‘setting’ of prices and price structures
by firms and the need to get prices correct for given market segments. As
Ofir and Winer put it:
Understanding price thresholds and willingness to pay is critical
to marketing managers’ being able to price appropriately and
not succumb to extreme pressure to drop prices.
(Ofir and Winner, 2002, p.278)

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If prices are too high, products will not sell, but low pricing represents
foregone revenue. In addition to supply and demand, four other factors
need to be considered.
• Cost. Generally marketing does not advocate pricing on cost; costs
merely set the floor. Pricing on cost (for example, as low as possible)
may be desirable as part of an entry strategy to gain market share,
but in the anticipation of future price rises away from this threshold.
However, the distinction between fixed and variable costs introduced
in Chapter 8 is important. Where fixed costs are high and variable
costs are low, firms will discount steeply at periods of low demand to
spread the fixed costs over as much revenue as possible; hotels and
airlines are good examples. Where variable costs are high, maximising
unit margins is much more important; in packaged foods, for example,
the materials and packaging in each item are a very high element in
total cost.
• Competition. If costs set the price floor, competition sets the price
ceiling. As we have seen, where competition is severe, differentiation
of the product by adding or subtracting features or attributes is often
the response. In many sectors, the dominant player exercises ‘price
leadership’ – for example, they set the price that others then follow.
• Consumer power. Again, we can refer back to the Porter framework
of Chapter 13. Where buyers account for a significant portion of sales,
and where they can also switch to other producers, consumer power
will translate quickly into price pressure. As an example, consider
the retail food market in the UK. The market is dominated by a small
number of large supermarket chains. To the producers of branded
foods, they control access to the consumer; they set prices and they
control the ways in which brands are presented in store. In addition,
for many standard items the ‘own brand’ offers consumers a low price
alternative. Their buyer power is considerable. For end consumers, it
may seem that individually they have little power, but they have almost
no switching costs between supermarkets, which thus offer ‘price
match’ promises in the face of collective buyer power.
Importantly, pricing is strategic. By this we mean that the firm will not
treat price as a dependent variable on costs or a revenue maximising
device in all cases. Here are examples of pricing ‘strategies’.
• Penetration pricing refers to a market entry pricing strategy
in which low prices are offered to build market share rapidly;
for example, new newspapers or magazines are offered at an
‘introductory’ price.
• Skimming pricing attacks those parts of a market where the highest
prices may be charged; for example, new electronic devices come to
market with a high price, which subsequently falls.
• Discriminatory pricing which targets different market segments
at different price levels; for example, restaurant chains differentiating
prices by residential district.
• Predatory pricing or low pricing to drive a competitor out of
the market; for example, the attack on early low-price transatlantic
airlines such as Laker and People by larger airlines dropping prices
only on that route.

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Table 19.1 summarises the factors that may affect firm price levels.
Negative Positive
High supply over demand Controlled supply
Intense competition High product value
Intrabrand competition Product differentiation
High buyer power High buyer dependency
Flexible costing High switching costs
Black markets for goods Price leadership
Table 19.1: Factors affecting price levels
19.6 Channels and distribution
The primary components of a distribution system are:
• sales representatives who are direct employees of the firm: they are
effective where the firm has clients who buy large quantities and need
technical support or customisation
• sales agents who are independent and carry the products of several
suppliers: unlike direct employees, they are a variable not fixed cost
since they generally work on commission
• distributors who deal with many suppliers and serve customers who
require small amounts but general availability: such distributors carry
large inventory costs but make margins on the ability to supply
• retail outlets and supermarkets: these are often independent of
the goods they sell (e.g. Wal-Mart) but they may be franchised
(McDonald’s) or wholly owned (Goodyear tyre stores in the USA).
Marketing began as the study of distribution and the choice of ‘channels to
market’ remains significant. Once chosen, such channels represent a sunk
cost for the firm and are difficult to change. Many traditional channels
have been hit hard (as we will see in the next chapter) by the rise of
internet shopping. Where vertical integration to the point of sale is too
costly or not feasible, firms deal with intermediaries (e.g. the distributors
mentioned above) with whom they must share the profitability of the
value chain. When working with intermediaries, the supplier must make
sure the channel works to its advantage; this is termed ‘channel support’.
Channel support has three objectives:
1. to make sure stocks are available to the end consumer at the resale
price
2. to make sure resellers actively display, advertise and promote the
product to end users
3. to maintain resale prices and make sure margins do not deteriorate.
If suppliers lose control over channels, they may experience ‘intrabrand
competition’; this occurs where a product is on sale at varying prices,
because of differential pricing by resellers (see Table 19.1). This may lead
both to foregone revenue and damage to the brand. Here is an example.
French wine producers sell into the UK market through supermarkets. The
price and quantity is defined by the buyer power of the final vendors. If
the final seller discounts the wine in store, the producer suffers two kinds
of disadvantage; first, loss of revenue, since the contracts specify payment
on the sale price and, second, damage to the brand if the consumer sees
the wine as cheap and therefore low quality. The final seller may discount

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the wine in order to encourage consumers into the store, but the wine
producer cannot diversify in the same way.
19.7 Brands and advertising
Many businesses advertise, and mostly what they advertise are brands.
The American Marketing Association yields the following broad definition
of a brand:
Some firms have many brands. For example, Unilever has Ben and Jerry’s,
Dove, Flora, Lipton, Signal and Surf. This is common in the packaged
goods sector; Unilever’s main competitor, Procter and Gamble, also has
many. Some brands have many firms. For example, the Virgin brand
does not involve just the Virgin organisation, but also Singapore Airlines,
Stagecoach, EMI and the Royal Bank of Scotland, among others. This
approach is known as ‘brand extension’, with the positive market value
(brand equity) of the brand extended across different sectors as a low-
cost way of effecting market entry. Brands are market differentiators, but
are not differentiated in production. Currently, a visitor to a major UK
supermarket such as Tesco may buy a branded tin of soup (e.g. Heinz) or a
lower-price, own-branded one (for example, Tesco) which may have been
made in the same production process. Coca-Cola branding signifies nothing
about the production process. Some very big brands, including Coca-Cola
but also Nike, Apple and Microsoft, can be identified simply by their logo.
Brands are said to have properties. Some, such as awareness, are
subject to quantitative measures, for example, how many consumers
have heard of the brand. They have more qualitative attributes such as
image, association and personality which are essentially measures of the
recognition or affective response the brand evokes with consumers. Some
even argue that brands give consumers ‘identity’ (Holt and Cameron,
2010). However, in business terms, brands are revenue streams and profit
opportunities. Companies develop brands mainly so that they can charge
more, increase new and repeat purchases and differentiate an increasing
set of products. Brands are bought and sold independently of the capacity
to produce the product or service they represent.
Brands are promoted mainly, but not exclusively, by advertising. A
prominent practitioner defines advertising more pithily than the AMA as
‘salesmanship mass produced’ (Hite in Pate, 1988, p.203). It is a species of
marketing promotion and as such has the following functions (Stewart and
Kamins, 2002):
1. to inform customers about products or offers
2. to persuade customers to buy
3. to remind customers of a product or brand
4. to act as a barrier to entry for potential new entrants by raising entry
costs.
A brand is a customer experience represented by a collection of
images and ideas; often, it refers to a symbol such as a name,
logo, slogan, and design scheme. Brand recognition and other
reactions are created by the accumulation of experiences with
the specific product or service, both directly relating to its use,
and through the influence of advertising, design, and media
commentary. A brand often includes an explicit logo, fonts, color
schemes, symbols, sound which may be developed to represent
implicit values, ideas, and even personality.

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This combination of possibilities helps to explain why many already
high-profile brands are supported by high levels of expenditure on
advertising. However, not all advertising supports brands. There are cases
where firms in an industry collude to increase demand for the industry’s
product; for example, they increase primary demand, as opposed to
increasing secondary demand for a specific brand within the industry.
A good example here would be advertising for milk products, which
in the UK and USA is funded by an industry body. In the USA, at least,
there is evidence that this form of advertising works: over the decade
1984–1993, advertising increased demand for milk by just over 1 per cent
and, more significantly, the price of milk by more than 14 per cent. This
is theoretically interesting since it is an example of advertising paying off
where all products are perfect substitutes.
Mostly, though, advertising is about differentiation to increase demand and
as such competes with the conventional way to increase demand, which
is to cut prices. So the decision on how much to spend on advertising is
potentially a difficult one since it is an attempt to increase demand at
constant or increasing prices. It thus turns into a calculation about the
price elasticity of demand. Dorfman and Steiner (1954) developed the
basic prescriptive formula as follows:
Advertising expenditure
Sales revenue
Advertising elasticity
Price elasticity of demand
=
So, if advertising elasticity = 2, then, for a given price–advertising
combination, sales will increase by 2 per cent if advertising expenditure
increases by 1 per cent. The same applies in reverse for prices; a price
elasticity of 2 means that sales increase by 2 per cent if price decreases by
1 per cent. The theorem shows that the sensitivity of prices depends on
advertising, and the sensitivity of advertising on price. The best position
for the firm is where price sensitivity is low and advertising sensitivity
high; substantial price rises can be sustained by moderate advertising
expenditures.
There are three implications to point out.
1. The more productive advertising is in raising sales, the higher will be
its proportion of sales revenue.
2. The greater the price elasticity, the less effective advertising will be
and the smaller the percentage of sales revenue. High-price elasticity
implies many substitute products.
3. Advertising should be highly effective for new products where there
are few comparable offerings, so the advertising-to-sales ratio will be
high at product launch. As the market becomes saturated, advertising
elasticity will fall, and one would thus expect the advertising-to-sales
ratio to fall across the life cycle of a product or brand.
This is essentially an equilibrium model, and one would expect advertising
expenditures to be triggered by external events. For example, we have
noted that advertising expenditures are used by incumbent firms as a
barrier to entry for new firms, and there is evidence that where there are
new entrants into markets, incumbent advertising expenditures spike.
Activity 19.2
Go to the Unilever website and estimate the number of brands it owns.Why are there so
many?

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19.8 Summary
We have focused on what managers do when they seek to manage
markets, under the conventional headings of product (including market
segmentation), price, promotion (including branding and advertising) and
place (channels and distribution). These are the ‘four p’s’ of marketing and
they constitute the elements of a marketing plan or strategy.
We have outlined the main elements of each and shown how they
interrelate.
• describe the main elements of marketing
• discuss their integration into a ‘marketing strategy’
• outline the key elements of branding and advertising.
Discuss your assessment of the case for marketing to be viewed as a
profession. How does this relate to both the nature of the responsibilities
that are given to the marketing function and also to the nature of the
actual job of a marketing manager?

Notes
168

Chapter 20: Marketing in the digital age
169
• discuss some business implications of internet technology
• describe the implications of the internet for marketing practice
• explain the role of branding on the internet.
Castells, M. The internet galaxy: reflections on the internet, business, and
society. (Oxford: Oxford University Press, 2001) [ISBN 9780199241538],
Chapter 3.
P. Barwise et al. ‘Marketing and the internet’, in Weitz, B. and R. Wensley (eds)
Handbook of marketing. (London: Sage. 2002) [ISBN 9780761956822]
pp.527–57.
20.1.4 Works cited
Achrol, S.R. and D. Kotler ‘Marketing in the network economy’, Journal of
Marketing 63 1999, pp146–63.
Carr, G.N. ‘Hypermediation: commerce as click-stream’, Harvard Business
Review January–February 2000, pp.46–47.
Chen, S.J and T-Z. Chang ‘A descriptive model of online shopping process: some
empirical results’, International Journal of Service Industry Management,
14(5), 2003, pp.556–69.
Degeratu, A.M., A. Rangaswamy and J. Wu ‘Consumer choice behavior in
online and traditional supermarkets: the effects of brand name, price, and
other search attributes’, International Journal of Research in Marketing,
17(1), 2000, pp.55–78.
Earl, M. ‘Evolving the e-business’, Business Strategy Review 11(2) 2000,
pp.33–38.
Hanson, W. Principles of internet marketing. (Cincinnati: S.W. College
Publishing, 2000) [ISBN 9780538875738].
Higson, C. and J. Briginshaw ‘Valuing internet businesses’, Business Strategy
Review 11(1) 2000, pp.10–20.
Hoffman, D.L., W.D Kalsbeek and T.P. Novak ‘Internet and web use in the United
States: baselines for commercial development’, Special section on ‘Internet
in the Home’, Communications of the ACM, December 1996.
McWilliam, G. ‘Building stronger brands through online communities’, Sloan
Management Review 41(3) 2000, pp.43–54.
Nelson, P. ‘Information and consumer behavior’, Journal of Political Economy,
78, 1970, pp.311–29.
Ward, M.R. and M.J. Lee ‘Internet shopping, consumer search and product
branding’, Journal of Product & Brand Management, 9(1), 2000, pp.6–20.

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20.2 Introduction
The purpose of this chapter is to understand the implications of the internet
for the practices of marketing discussed in the last chapter, and in particular
to look at the implications for branding. The growth of electronic marketing
has been spectacular since the early 1990s, but it has not been linear. In
particular, the so-called ‘dot.com’ boom up to 2000 and the subsequent
crash in 2001 exposed as wildly optimistic many business models based on
the internet’s technical capabilities alone. Some of the largest companies in
the world, such as Google and Amazon, are based on internet technology,
but many start-up internet businesses failed to establish revenue models
that would ensure their survival and company failures were extremely
common in the early years of the century (Castells, 2013).
The internet remains at the forefront of marketing developments based on
the following properties.
• It allows faster and cheaper interactions than any previous medium.
It can also personalise transactions based on recorded customer
knowledge; this raises privacy concerns.
• It can dramatically reduce customer search times and indeed can use
software to help the customer decision process. The prerequisite is that
the customer must have some information on what is being searched
for.
• It is globalising in two senses. First, it renders geographic distance
irrelevant to the transaction (but not to its fulfilment). Second, it
supports instant translation into a large number of languages.
• It is ubiquitous, allowing ‘24/7’ communications. Subject to internet
connection, the location of the consumer is irrelevant.
• It can be accessed through and supports a range of different
technological devices, including phone, PC, tablet and TV.
This gives it the potential to affect many of the dimensions of marketing
discussed above: segmentation, pricing, customer service and relationship
management, advertising, channels, value chains and brands. In addition
it may have added a dimension to marketing. Traditionally, marketing
distinguished business to business (B2B) marketing from consumer
marketing (B2C). The internet is relevant to both, and has developed the
idea of consumer-to-consumer (C2C) interactions. Two examples are, first,
the importance of consumer ratings to other consumers and, second, the
support of C2C transactions. Sites such as Travelocity are distinct from
more traditional marketing modes in the specific sense that they are the
agent of the buyer rather than the seller, acting as customer consultant
by coordinating opinions (Achrol and Kotler, 1999). C2C transactions are
supported on auction websites such as eBay, a large proportion of whose
revenues come from consumers rather than businesses.
The internet has had a substantial impact on existing businesses, not
least in the emergence of email as the primary vehicle for intrafirm
communication, but here we focus on the marketing aspects of it − and
there are great differences to be observed. For example, almost all large
businesses invest substantial amounts into their websites, but Tesco
sells high volumes and generates revenues through its website whereas
Mercedes mostly advertises through its own website, while still selling
predominantly through dealerships. This implies substantial variance
in impact. But as we have seen, the internet also generates large new
businesses. In order better to understand both sets of dynamics, let us take
a case study of the largest electronic retailer in the world.

171
Mini-case activity
Amazon
Amazon was founded in 1994 by Jeff Bezos, whose previous experience was on Wall Street.
It began in his garage; today (in 2013) it is the largest electronic retailer in the world with a
market capitalisation of over $8billion and 97,000 employees worldwide.The business model
is distinctive. Bezos was not a technological entrepreneur like so many dot.com CEOs. He was
looking for a way to make a successful business out of the internet and initially examined
the prospects of selling several products, including CDs, videos, games, books and software
on the internet.The model was a simple sales revenue one, where sellers ceded to Amazon
a proportion of the customer revenue and also paid to be ‘featured items’.The business plan
specifically allowed for no profit to be made in the first five years.
Amazon initially allowed global access to its US website but subsequently set up sites in other
countries to which consumers were channelled.There are also a large number of distribution
centres. Customers’ search and purchase history is monitored and provides the basis for
recommendations which customise the website when they log in. For many customers, this is
augmented by frequent emails highlighting products. Credit card and delivery details are held
and password-protected. Software such as ‘1-click’ facilitates speedy purchase. Most goods,
excluding ebooks, are delivered by courier; customers have a price list of different delivery
options.
Amazon began with books. It had a major impact on traditional booksellers such as Barnes
and Noble in the USA.The business models were very different. Barnes and Noble had to invest
substantially in property for outlets and in stocks of books so that customers could browse.
Amazon held little stock – it acted as a broker – and few properties. Interestingly, the markets
positively evaluated Amazon’s performance even though it made losses in this period.Whereas
investors looked at Barnes and Noble as a retailer and examined measures such as ROCE,
Amazon was evaluated by looking at traffic measures – a common measure for an internet
business.
Subsequently,Amazon diversified into thousands of different products, including its own-
branded ebook readers – the Kindle – and was reliant on its own electronic delivery system.
It also offers music downloads. But many products are branded household and personal
items such as would be available in a conventional department store or supermarket. It thus
competes with many conventional retailers, and with Apple. In the third quarter of 2013, its
sales exceeded £17 billion. Its mission statement is primarily about marketing, for example: ‘We
seek to be Earth’s most customer-centric company for four primary customer sets: consumers,
sellers, enterprises, and content creators.’
Question: Faced with competition from Amazon, what can Barnes and Noble do?
Here are some generic marketing points to draw from this brief case.
•• Products. Some products are more suited to web sales than others.The characteristics
of those chosen originally by Bezos were that they were standardised, branded and have
a high value to weight ratio. Information on product attributes was more important than
sensory attributes; for example, the products did not have to be seen or handled prior to
purchase (Degeratu et al., 2000).
•• Customisation.Amazon reduces customer search times by customising the site on arrival.
As the scale and complexity of the site increases, customers get more specific guidance
based on their purchase history.The site is both a destination site for purchases and a
search engine for products (Hoffman et al., 1996).
•• Web interface.The site is both a distribution channel for goods and an advertising site
for market communication. Both functions support revenue streams.The site allows speedy
purchase, but also encourages customers who wish to search and browse.

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20.3 Impact on conventional businesses
Amazon is a good example of a successful internet firm. But several
conventional retailers have ended up with a so-called ‘bricks and
clicks’ combination by making something of a reverse journey – from
conventional to electronic selling. This journey is characteristic of many
retailers in the UK who maintain physical retail outlets. This journey has
been described by several authors, including Earl (2000). He identifies six
stages of evolution as follows.
1. External communications. The company uses web technology to
communicate with customers and the principal requirement is constant
and efficient content management.
2. Internal communications. The company relies on the web
internally for communication and information management and the
principal requirement is architectural integrity of the system.
3. E-commerce. The business uses the internet for sales and the
principal requirement is for an electronic channel strategy alongside
conventional ones.
4. E-business. The company seeks to develop an internet-based
business model and the key requirement is for high-performance web-
based processes.
5. E-enterprise. The company understands that it is primarily in the
information business and the key requirement is information literacy.
6. Transformation. In this stage the company ceases to discriminate
between internet and conventional methods and the key requirement
is for continuous learning and change.
Not all companies are capable or willing to go through all these steps
but three issues that most will face concern channels, products and
advertising. We look at each in turn.
•• C2C. Products come with customer recommendations based on a star system, allowing
customer networks to form.
•• Fulfilment.Amazon requires a substantial investment in delivery (fulfilment) supported by
a scalable international distribution system. Chen and Chang (2003) found that the three
elements of successful online shopping were the customer’s encounter with the interface
(web design), the quality of the purchase experience (mainly speed – a high proportion of
web transactions are not completed) and fulfilment (reliability and speed of delivery, plus
returns policy).
•• Brands.Amazon began by relying on standardised products with recognisable brands
to reduce customer uncertainty. However, the Amazon brand itself has developed over
time to attract suppliers interested in sales and consumers interested in purchase. Even
competitors such as Apple sell through the site.
There are many more general points to draw from the case. From a marketing perspective,
we will limit ourselves to two. First, the capital requirements for an electronic retailer relying
on physical distribution are substantial, and Amazon has benefited from substantial first-
mover advantage since the barriers to entry are high. Second,Amazon has itself built a very
reliable brand, and one which shows up in other search engines; Bezos deliberately chose
a name beginning with ‘A’.Amazon’s growth has probably had a major negative impact on
conventional retailers such as Barnes and Noble, but it has generated major spin-off benefits
for the packaging and postal industries.

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20.3.1 Channels
One of the earliest claims about the role of the internet was that it would
reduce search costs for consumers and reduce profits. Others argued
that value chains would be disrupted and in particular all intermediaries
between the manufacturer of a product or the originator of a service
would be disintermediated – that is, their role would disappear. In this
view, wholesalers, resellers and retailers would simply be substituted by
a direct relationship between producer and consumer on the web. The
information value added by intermediaries would disappear.
There is little doubt that some disintermediation has taken place (Barwise
et al., 2002). However, they argue that intermediation has changed rather
than disappeared. Citing Carr (2000), they argue for ‘hypermediation’ in
that web transactions:
… routinely involve many intermediaries – not only wholesalers
and retailers but also content providers, affiliate sites, search
engines, portals, internet service providers, software makers…
(Barwise et al., 2002, p.544)
They argue that many of the benefits of internet retailing accrue to such
intermediaries.
20.3.2 Products
One broad question concerns which types of product can be sold through
the web and which cannot. Our Amazon case study indicated that early
success was associated with standardised products. The conventional
wisdom was based on the argument by Nelson (1970) about the
distinction between a ‘search’ and an ‘experience’ good; search goods are
those whose quality could be judged by inspection alone; experience goods
are those whose quality can only be judged through usage. Initially, it was
felt that only the former could be sold through the web. However, sales
of products which are not standardised (flowers) or which are experience
goods (wine) have grown on the internet in recent years and it may be
that consumers are prepared to trust the brand of the internet retailer in
these matters. One category resilient to internet retailing appears to be
certain luxury goods. One possibility is that where the shopping experience
itself constitutes part of the customer value, the internet is not favoured.
20.3.4 Advertising
The web is widely used for advertising and some major internet operators,
notably search engines, rely heavily on it for revenue. Key issues are, first,
how to drive traffic to the website concerned and, second, the breadth and
depth of customer usage.
A good example of the first point comes from the growth of Hotmail. Users
of Hotmail have an incentive to encourage others to act similarly; this is
free. This reliance on electronic word of mouth is termed ‘viral marketing’.
Prior to the dot.com crash, traffic was used as a predictor of future
revenues, not least because it was seen to attract advertising revenue.
However, in the crash it appeared that overspend on marketing relative
to revenue was one of the main causes of failure, particularly for B2C
businesses (Higson and Briginshaw, 2000).
Breadth and depth are two measures of website usage. Breadth refers to
how many web pages a user looks at, and depth to how long they spend
on the site. Both are seen to be important for advertising effectiveness,
but there is a clear issue of conflict between efficiency of search and
purchase, on the one hand, and spending time looking at advertising, on

174
the other. Researchers have looked at the style, frequency, content and
copy quality of web advertising to try to assess its effectiveness, although
(as with conventional advertising) the question is whether the appropriate
success measure should be direct (sales) or more diffuse (long-term brand
building) (Barwise et al., 2002).
Advertising is often categorised as pull or push. Pull media are initiated
by the customer, for example, classified advertising in newspapers, where
the reader must turn to the page concerned. Push media are those where
the consumer has little choice – which reflects the more conventional
advertising that takes place on television or in the cinema. Internet
advertising mixes both, but the pull model has been dominant.
20.4 Internet and branding
There has been a debate about whether use of the internet strengthens or
weakens brands. Information economics would suggest weakening. The
argument is that, initially, consumers would be less proficient at search
and would rely on brands to reduce uncertainty of internet purchasers but,
as proficiency improved, they would become less reliant on brands, and
thus brand advertising would become less useful (Ward and Lee, 2000).
In this approach brand advertising is a substitute for efficient search in
encouraging purchase. The broader argument is that the internet has no
special properties – it is merely a more efficient shopping channel.
The counter-argument relies on these special qualities, specifically that
C2C capabilities can build online brand communities that generate
increased customer loyalty. It has been argued, for example, that eBay’s
auction system encourages C2C communication (Barwise et al., 2002).
However, this differs from the idea that there is benefit in building
an online community for an existing brand. There is evidence that
membership of an online brand community can affect the components of
brand equity (perceived quality, brand loyalty, awareness and association),
but, on the other hand, there are also issues about how firms, accustomed
to controlling these facets, can control an online community with a small
number of active participants relative to the customer base (McWilliam,
2000).
20.5 Summary
There is evidence that online technology has potential to:
• reduce customer search costs
• allow low-cost customisation of marketing
• support online brand communities
• enhance customer access to firms
• abolish some types of intermediary and create others
• enhance C2C communication.

175
• discuss some business implications of internet technology
• describe the implications of the internet for marketing practice
• explain the role of branding on the internet.
How would a marketing strategy for an internet-based business differ from
that of a conventional one?

Notes
176

Appendix 1: Syllabus
177
This is a description of the material to be examined, as published in the
Regulations.
Introduction
This chapter introduces the course and its approach. It discusses the pre-
industrial roots of thinking about management and leadership, and shows
the longevity of certain management practices. The industrial revolution
prompted major developments in social theory and political economy – in
particular in Europe and USA – which in turn have influenced the analysis
of management in business. The chapter traces the roots of modern
management technique in the developing disciplines of the social sciences
and offers a framework for a critical understanding of the corpus of
business knowledge.
Management and the Firm
The chapter looks at the growth of large firms in historical context and
examines the major explanations for the growth of firms, specifically
technological indivisibility and market failure. It specifically examines the
work of Chandler. It describes the separation of ownership and control and
introduces the problem of agency. It introduces the ‘varieties of capitalism’
debate and covers the varieties of institutional arrangements for firm
governance that have emerged in advanced economies. The relationship
between the factory system and the creation of an industrial workforce is
discussed.
Taylorism, Motivation, and Performance
This chapter looks at the emergence of two important schools in the
history of management science that attempt to systematically analyze
human behaviour at work: 1. Taylorism and scientific management; and
2. the development in psychology and the human relations movement. If
offers an overview of the background, principles, as well as limitations and
problems of the two schools. Performance appraisal systems and reward
systems in organisations are examined as well.
The Rise and Decline of Labour
This chapter looks at the historical root of industrial and labour relations
and explores the linkage between workplace control and the broader
economic and political context of work organisations. The evolution
of internal labour market, the logic of collective action, and wage
determination and rent-sharing in collective bargaining are examined.
The chapter also introduces the markets for trade unionism and the
mechanisms that unions grow. It overviews the rise and fall of trade unions
with reference to historical and contemporary influences. Alternative
voices schemes are explored at the end.
The Rise of Human Resources Management
This chapter looks at the origin and evolution of the field of human
resources management (HRM) and introduces key theories and
analytical concepts of HRM. The chapter will provide a framework for
thinking systematically and strategically about aspects of managing the

178
organisation’s human assets. Major approaches to HR strategy—Michigan
School, Harvard School, and Resource-based models will be discussed.
Origins of Management Science
This chapter will look at the development, post-Taylorism, of quantitative
modelling approaches to operations management. Basic concepts of
queueing systems and inventory control, and linear programming will be
introduced and placed in context. We will discuss how these concepts have
been developed as organisations have become more complex, and more
mature in their ability to process data and harness computing power. We
will also talk about how these ideas have spread beyond the engineering
and manufacturing settings in which they were first introduced, and some
of the challenges facing the implementation of these management science
concepts in these new environments.
• Ideas of inventory theory like EOQ/newsvendor
• Basic queueing models, M/M/1, M/M/k—focusing on graphical
presentation and insights (no proofs)—basic equations and say the
real world more complex but the basic insights hold.
Accounting, finance and the firm
The chapter will comprise a review of models of agency provided by
principal agent theory, behaviouralism and the theory of the firm provided
by Rajan & Zingales (1998). It would also introduce accounting theories
that do not utilize such models, such as the critical accounting school.
These theoretical perspectives will constitute reference points for case
discussion in later weeks. We will be drawing on discussions of principal/
agent theory and behaviouralism provided in earlier chapters within the
course.
Management Accounting: Costing
This chapter will introduce management accounting as a set of practices
relating to the internal control of the corporation and their evolving role
in facilitating decision making by managers. Then focus will be placed on
costing. We will distinguish between direct and indirect costs, and between
standard costing methods and Activity Based Costing. We will place issues
relating to costing in historical perspective and drawing on Johnson &
Kaplan’s Relevance Lost, make comparisons with costing in earlier periods.
Management accounting: Decentralization and performance
measurement:
This chapter would introduce themes in management account relating
to the collecting, processing and analysis of information regarding the
internal functioning of the firm. We will investigate the relationship
between performance measurement and decentralized forms of
organization. Following a review of different aspects of management
accounting, we will cover issues agency and institutionalist perspectives on
performance measurement. We will then cover the Balanced Scorecard.
Financial accounting
This chapter will introduce the three elements of the financial report,
namely, the balance sheet, the profit and loss statement and the cash
flow statement. We will discuss the qualitative requirements of financial
accounting for relevance, reliability, comparability and understandability.
We will also look at processes for setting financial accounting standards.

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Modern Portfolio Theory
This chapter will first introduce the financial framework relating to risk
and reward and place this in the context of the characteristics of different
asset classes. We discuss issues relating to asset allocation, long term rates
of return of different asset classes, the research on the relative returns of
asset class selection and security selection.
Security analysis and valuation
We draw on the previous chapter in examining different financial ratios
and their application in conducting financial analysis of firms. In the latter
part of the chapter we will extend this discussion to revisit issues relating
to mergers and acquisitions.
The Origins of Modern Strategy
This chapter will focus on the origins of the strategic management
discipline. The chapter will emphasise what differentiates thediscipline of
strategic management from its sibling and parent disciplines. Particular
attention will be paid here to understanding its level and units of analysis,
principal questions, primary assumptions, typical research methods
and key debates. The early ‘pre-theoretic’ schools that characterised the
youthful strategic management discipline in the 1960s and 1970s will
be surveyed. In addition, the influential ‘positioning school’ work of
Michael Porter from the 1980s with its focus on industry analysis will be
introduced.
Understanding Organisational Structures
The chapter examines structural options. Beginning with the Weberian
concept of bureaucracy, it discusses the development of formal rational
hierarchies in business. It covers the work of Mintzberg and Scott. It
examines explanations for the rise of m form organisations (Coase,
Williamson) and introduces the concept of matrix organisation. Finally, it
discusses institutional theories and the pressures of isomorphism.
Analysis of Organisations
This chapter analyses the development of theories of organisation,
dealing with both sociological and economic approaches and examining
ecological and institutional theories of organisational fields. It looks at
the connection between the study of organisational forms and fields, and
examines network theories of organisation
Contemporary Strategic Management
This chapter will examine the most prominent theoretical perspective
to emerge in the strategic management discipline in recent decades:
the Resource-Based view (RBV) of the firm. The emergence of this re-
focus on the ‘internal’ elements of company strategy will be placed in
disciplinary context. Major works of both scholarly (e.g. Jay Barney,
Kathleen Eisenhardt, and Bruce Kogut) and practitioner-oriented RBV
authors (e.g. Gary Hamel and C.K. Prahalad) will be reviewed to provide
a representative picture of the concerns, methods, findings, and debates of
the RBV (and associated Knowledge-Based View) theoretical perspectives.
The chapter will conclude with a discussion of cutting edge trends in
strategic management theory and practice.

180
Strategy and Decision Making
This chapter will trace the evolution of behavioural decision theories
from their origins in the 1950s to the present day. Behavioural theories
are normally based on (i) a concept of a “good” or “rational” approach to
decision making; (ii) empirical evidence which shows that people do not
follow such an approach; (iii) a theoretic account of why such departures
from rationality occur, and, sometimes (iv) some suggestions as to how to
help people make more rational decisions. In this chapter we centre mostly
on the celebrated “heuristics and biases” tradition of Kahnemann and
Tversky, showing how the theory which these authors developed can shed
light on both economic behaviour and managerial decision making. We
also discuss some of the controversies surrounding this theory and some
alternative views.
The Origins of Marketing: The Development of the Theory
Marketing theory approaches, like marketing itself have to span both
the level of individual behaviour, which tends to be most informed by
economics and psychology and aggregate behaviour and organisational
relationships where sociological and again economics approaches provide
much of the initial theoretical background. On top of this much of the
aggregate work also relies to a considerable extent on advanced statistical
techniques.
The Origins of Marketing: The Development of the Practice
The practice of Marketing has emerged from a number of different
“traditions”, including business journalism, advertising, selling and,
rather later, market research. We will look in more detail at the historical
development of one of these traditions: advertising, to illustrate in more
specific terms, the recurrent themes particularly in terms of the issue
of practice and professionalisation but also allied issues such as the
knowledge base, the questions of standards and the nature of regulation.
We will then consider the more recent manifestation of these issues in both
a US and a UK context.
Future Challenges for Marketing in the Digital Age and the role of
Branding
It is perhaps an inevitable characteristic of the area of marketing that it has
to confront questions of change both within the organisational function
and also in the wider market environment. We will look at two key areas:
the claims and evidence for the changing nature of the communications
and promotion activity in responding to the shift from “broadcasting” to
“narrow-casting” and the extent to which a more interactive relationship
with customers is changing the underlying rationale of many marketing
activities. We will finally consider one area of apparent continuity: the
inexorable rise of the notion of “The Brand”.

Core Management Concepts (UOL Subject guide)

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Core Management Concepts (UOL Subject guide)