chapter
stringlengths 1.97k
1.53M
| path
stringlengths 47
241
|
|---|---|
Human society depends crucially upon a series of infrastructure investments that have been made over centuries of time. We have constructed water, wastewater and power systems, as well as buildings, roads, ports, railways and other facilities. More recently, we have built complex telecommunication systems. In the process, humans have profoundly altered natural landscapes and ecological systems. The result has been a large number of inter-dependent infrastructure systems to support economic activity and social welfare. Without our infrastructure, society would not function in anything like its current state. We all have come to depend upon electricity from our power grid, goods delivered from our transportation systems, clean water from municipal water supplies and sewage services. In effect, infrastructure investment is a major social commitment, but it enables a great variety of economic and social activities.
With our dependence upon infrastructure, it is not surprising that the management of our infrastructure is a critical economic and social task. Infrastructure wears out during use, deteriorates over time due to aging and weather effects, and can fail due to extreme stress from events such as earthquakes or floods. Maintaining, rehabilitating and renewing our infrastructure systems are a major undertaking for any society.
There is no widely accepted enumeration of the number and extent of infrastructure systems. Some analyses focus solely on publicly owned infrastructure, but this omits major systems in many countries, such as railroads in the United States. The American Society of Civil Engineers provides ‘grades’ of the condition of 16 different types of US infrastructure (ASCE, 2016), while the U.S. Department of Homeland Security’s National Infrastructure Protection Plan identifies 18 types of infrastructure (DHS, 2016). The National Resource Council defines five ‘critical infrastructure systems:’ power, water, wastewater, telecommunications and transportation systems (NRC 2009).
Defining the extent of infrastructure is difficult also due to the complexity of components within any type of infrastructure. For example, roadways have a variety of constituent infrastructure systems themselves, including:
• Pavements and pavement markings;
• Tunnels and bridges;
• Drainage and foundation support;
• Sidewalks and
• Signage and traffic control infrastructure.
Each of these roadway components can be treated as its own infrastructure system to be managed. Similarly, buildings have a variety of sub-components and systems to be managed.
For the purposes of this book, we will take a broad view of infrastructure systems, including both critical and mundane facilities and components. Infrastructure managers will certainly vary in the extent of their interests and management responsibilities, so taking a broad viewpoint on what constitutes infrastructure is appropriate.
1.02: Goals for Infrastructure Management
Just as the number and extent of infrastructure systems are complex, so are the goals that are pursued for any particular infrastructure system. One common goal suggested is to ensure ‘sustainable’ infrastructure. One interpretation of sustainability is simply to have facilities with great longevity. However, this is often not a realistic goal. First, managers must be sensitive to the amount of resources required to construct and maintain any particular facility. Longevity requires greater capital investment for initial construction. Second, the requirements for facilities are likely to change over time. For example, the legal size and weight of trucks can change over time (usually with an increase), which may make existing bridges functionally obsolete since they cannot support larger trucks. Third, the usage of facilities may decline to such an extent that maintaining an existing facility is not beneficial.
For most infrastructure systems, managers adopt a planning horizon for longevity decision making. Such planning horizons can vary from a short period (such as a year or two) to decades (for infrastructures such as ports or buildings). Each organization involved in infrastructure management may have its own planning horizon for such decision making.
In practice, the goals for infrastructure management are complex and multiple. Most critically, facilities are expected to provide acceptable performance to a variety of users. For example, a local roadway might accommodate a variety of motorized vehicles (such as buses, cars, and trucks - moving or parked), bicycles and pedestrians (particularly at intersections). Deterioration of the facility can affect acceptable performance, as with the development of potholes, uneven surfaces and cracking for pavement. Extreme events such as earthquakes, hurricanes, flooding or terrorist activities can require immediate attention and response.
Typically, goals for infrastructure management can be categorized as economic, environmental and social. Economic impacts include the direct and indirect costs of managing and operating the infrastructure system, the economic development potential for the system (including employment) and any user or non-user benefits stemming from the system. Environmental impacts are associated with ecological system uses, emissions to the environment (especially toxic chemicals and greenhouse gas emissions), and non-renewable resource use. Social impacts pertain to equity of benefits, social justice and individual development (including employment). This ‘Triple Bottom Line’ of goals is common for many social investments.
1.03: Role of Infrastructure Managers
Infrastructure managers are becoming increasingly important in the agencies and owners of infrastructure. Throughout the world, centuries of infrastructure investment have resulted in complex, multi-layered systems of existing infrastructure. Maintaining this infrastructure investment is a major task as noted above.
The skills required of infrastructure managers will vary from place to place but have some common elements. Managerial skills for setting priorities, communication with multiple stakeholders, building effective teams and proactive problem solving are always desirable. Technical familiarity with information systems and infrastructure systems is highly desirable, although managers can often rely upon their management team for relevant technical expertise. Developing rapid and effective responses to component breakdowns and extreme events such as floods or earthquakes is also a major role for infrastructure managers.
The background and career paths of infrastructure managers can also vary. Traditionally, many managers rose through the ranks of skilled tradesmen such as mechanics or construction workers. More recently, professional backgrounds in architecture, engineering, or business have become more heavily represented among infrastructure managers. With any background, it is imperative for infrastructure managers to stay current with new technologies and issues affecting their work.
Rather than a holistic overview for infrastructure management, many managers are charged with responsibility for single components or even single attributes of components. For example, Infrastructure systems along a neighborhood street might include:
• Roadway pavement
• Electricity
• Tele-communications
• Potable Water
• Natural Gas
• Wastewater Sewer
• Storm Sewer
Each of these systems may have separate owner organizations and managers. One system might have multiple managers. For example, the roadway pavement may have different managers for snow removal, routine cleaning and rehabilitation and maintenance. As might be imagined, co-ordination in the management of these different systems may be difficult. The infrastructure managers involved should make special efforts to insure information sharing and co-ordination. For example, roadway rehabilitation could be usefully coordinated with work on other underground utilities to avoid repeated excavations. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/01%3A_Introduction_to_Infrastructure/1.01%3A_Importance_of_Infrastructure.txt |
A variety of industrial and professional organizations have emerged to provide a forum for infrastructure managers and indeed to support the notion that the discipline itself represents a discrete field of study within the engineering profession. These organizations provide a means of spreading relevant information, such as best practices and job availability. However, these organizations often are limited to particular types of infrastructure or specific regions or countries. A partial list of related professional organizations associated with the practice of infrastructure management in the United States is listed below:
• APPA (www.appa.org) Association of Physical Plant Professionals
• ASCE (www.asce.org) American Society of Civil Engineers
• ASME (www.asme.org) American Society of Mechanical Engineers
• SAME (www.same.org) Society of American Military Engineers
• BOMA (www.boma.org) Building Owners & Managers Association
• IFMA (www.ifma.org) International Facilities Management Association
• AFE (www.afe.org) Association of Facility Engineers
1.05: Chapter 1 Excercises
(6 pts)
The ASCE produces a periodic report card on the nation’s infrastructure system (See the ASCE readings) Pick 2 of the following infrastructure systems: Bridges, Dams, Drinking Water, Energy (Electricity), Hazardous Waste, Public Parks & Recreation, Roads, Solid Waste, Transit, and Wastewater.
(a) Provide a grade for the local systems at in Pittsburgh using just three categories for grading: condition, capacity, and adequacy of funding. (Note that the ASCE methodology includes seven categories).
(b) Document a justification for your grade (in a fashion similar to that in the ASCE report card site listed above). If you have no data for a particular category, just say so.
(c) Contrast your local grade with the national ASCE grade in the reading.
(10 pts)
Provide a critique and summary of one paper published in a refereed ASCE (or other professional society) Journal in the past ten years pertinent to infrastructure management. Your critique and summary should be no more than three pages long. ASCE journals are listed at:
ascelibrary.org/action/showPu...ubType=journal
Feel free to pick a journal that reflects your own interests. Good starting points are the Journal of Infrastructure Systems or the Journal of Architectural Engineering. This assignment is intended to introduce you to the professional literature as a resource for infrastructure management.
Your summary should include:
1. the full reference for the paper (authors, title, journal, volume, number, pages, publication date),
2. a summary of the content of the paper,
3. the implications and usefulness of the results for infrastructure managers,
4. any problems you see with the paper (such as needed further work), and
5. the contribution of the paper with regard to other published work, including the
references cited and any citations to the chosen paper.
and report the results. In many cases, your chosen paper may be too recent (or too obscure) to have had citations.
1.06: Chapter 1 References
References
• (ASCE 2016) American Society of Civil Engineers, 2013 Report Card on America’s Infrastructure, http://www.infrastructurereportcard.org/ (accessed 1/5/2016).
• (DHS 2016) Department of Homeland Security, ‘National Infrastructure Protection Plan,’ http://www.dhs.gov/national-infrastr...rotection-plan (accessed 1/5/2016).
• (Hendrickson 2016) Hendrickson, Chris, ‘Project Management for Construction,’ http://pmbook.ce.cmu.edu/ (accessed 1/6/2016).
• (Hendrickson 2016b) Hendrickson, Chris and H. Scott Matthews,’ Civil Infrastructure Planning, Investment and Pricing’, http://faculty.ce.cmu.edu/textbooks/cspbook/ (accessed 1/6/2016).
• (Matthews 2016) Matthews, H. Scott, Chris Hendrickson and Deanna Matthews, ‘Lifecycle Assessment: Quantitative Approaches to Decisions that Matter,’ http://www.lcatextbook.com/ (accessed 1/6/2016).
• (NRC 2009) National Resource Council, ‘Sustainable Critical Infrastructure Systems: A Framework for Meeting 21st Century Imperatives,’ National Academies Press, 2009, DOI: 10.17226/12638). | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/01%3A_Introduction_to_Infrastructure/1.04%3A_Organizations_for_Infrastructure_Management.txt |
Actively managed infrastructure systems typically have a structured process for asset management. Such processes are usually planned for regular time intervals such as annually or every five years. Asset management does require resources of various types. But with an asset management process, owners can reduce the risk of unexpected infrastructure failures and plan for preventive maintenance to reduce lifetime infrastructure costs.
In many cases, owners are required to have an asset management process in place by lenders or regulators. In such cases, the lenders or regulators may be interested in estimates of the value of infrastructure assets in addition to appropriate management actions. An example is the standards recommended by the Government Accounting Standards Board (FHWA 2000). Since sale of infrastructure assets happen only sporadically, the ‘value’ of infrastructure is usually estimated as either the original acquisition or construction cost less depreciation over time, the cost of replacement, or the cost of preservation for the infrastructure.
Depreciation is an accounting term that represents a loss in value over time and is usually considered a cost of business. For many infrastructure systems, depreciation is calculated as a linear loss of value over the expected lifetime of the system. So if the original construction cost was C, the expected lifetime is n years, then the depreciation in each year is C/n and the estimated value of the system in year t (counting from the time the infrastructure is constructed or acquired) is
\[value = C – t(C/n)\]
For example if \[C = \$ 10 million\] \[n = 50 years\]
Then depreciation in each year is \[\$ 10,000,000/50 = \$ 200,000\] and the ‘value’ in year 10 is \[\$ 10,000,000 - 10*\$200,000 = \$ 8,000,000\]
While we focus on infrastructure assets here, assets to a particular enterprise will often comprise a wide range of resources. Employees are assets whose value can improve with experience, education or training. Likewise, inventories of goods and real estate are assets. Even reputations are viewed as assets and can be subject to an asset management process.
2.02: Usual Elements of an Asset Management Process
Figure 2.1 illustrates the typical steps in an asset management process. These steps would often be undertaken on an annual basis, although many of the elements might not change from year to year such as goals and policies. In the remainder of this section, we will comment upon the various components in the generic asset management systems in Fig. 2.1. Later chapters will examine these process steps in greater detail.
Goals and policies will differ among enterprises. For example, a water provider (e.g., a water utility) might have goals to provide a certain quantity of water within defined quality standards. Further, the water provider might have goals to preserve its physical infrastructure at a certain quality standard. A major difference in policies concerns corporate taxation. For private corporate-owned assets, the tax implications of depreciation and maintenance expenses may be important in the overall profitability of the corporation. Infrastructure managers must assess the specific goals and policies pertaining to their own enterprise.
Asset inventory identifies the numbers and types of assets available. For example, a roadway agency might keep track of the numbers and types of roads in their system, but also assets such as road signs and lane markings. Inventory is often hampered by the absence or loss of historic records, such as the exact locations of old underground pipes. Inventory changes over time as assets are created (through construction or purchase) or disposed of (through retirement or sale).
Computer aids are available for asset inventory. For fixed in place assets, geographic information systems may be quite helpful, showing the location and types of assets visually on a computer screen (Figure 2.2 provides an example of such a GIS inventory). For these aids, a standardized labeling or numbering system for assets is required. These identifiers are usually stored in an inventory database of asset information, but also installed on pieces of infrastructure themselves. For example, railway cars will have a standardized ‘reporting mark’ to indicate the owner of the car and its number. The identifiers may be written on the assets or stored in readable digital form by technologies such as radio frequency identifier (RFID) tags or bar codes. In many cases, computer aids pertain to individual assets such as bridges or roadway segments, and some form of ‘data gateway’ may be required to provide a holistic view of enterprise assets.
Condition Assessment and Performance Modeling requires an assessment of the current functionality of each asset and often involves a forecast of asset deterioration. Condition assessment can be done mechanistically by assuming a standard deterioration with use and time, but more often involves active survey and/or sensing along with models of performance and deterioration. In many cases, condition assessment is summarized in a numerical rating score based on a survey, sensing or testing. Figure 2.3 shows a pavement segment having less than perfect conditions as an example.
Alternatives Evaluation and Program Optimization is a process step to plan asset maintenance, rehabilitation or replacement for the planning horizon. In this step, managers need to formulate reasonable alternatives for asset improvement. For a roadway segment, alternatives might include various maintenance activities (such as crack sealing or pothole patching), repaving (such as milling off the top layer of asphalt and placing a layer of smooth, recycled asphalt), or reconstruction. Of course, any asset management plan will have to be modified over time in response to changing conditions or priorities.
Computer aids can also be useful in the process of alternatives evaluation and program optimization. Databases of possible alternative actions (and their costs and other characteristics) are helpful. Optimization programs to minimize costs may be employed. Alternatives evaluation can also involve multiple stages, with preliminary investigation followed by a detailed analysis of a final set of possible actions.
Budget and Allocations define the resources available for asset management and will influence selection of management alternatives. In effect, most infrastructure managers are constrained by the allocation of resources and budgets available in any particular period. As shown in Figure 2.1, budget and allocations may also influence the goals and policies defined for the entire process.
Short and Long Range Plans (Project Selection) develops a plan of action for selected alternatives over periods of time. ‘Short-range’ typically is a yearlong planning
horizon, although it might be as short as scheduling activities over the course of a day or week. Long-range plans usually involve major projects and may involve a significant planning process. For discussion of long-range planning, see Hendrickson (2016). Plans usually involve the infrastructure management organization itself, but often include provisions to contract out for specific projects.
A component of most infrastructure management short-range plans is a process for responding to routine maintenance requests. For example, a building manager might have a systematic plan for replacing light bulbs in the building, but would also respond to reports of burnt out or broken lights.
Program Implementation is the process of actually completing the selected projects. For example, a City might plan to repave 200 kilometers of designated roadway segments over the course of a construction season. Program implementation involves actually doing the repaving work.
Performance Monitoring (Feedback) is a means of providing continuous feedback information on asset management performance. While Fig. 2.1 shows this feedback as a flow into goals and policies, the feedback can influence all stages of the asset management process. For example, the performance of particular maintenance or rehabilitation alternatives may inform alternatives evaluation and project selection. Performance monitoring often involves measures of infrastructure usage and quality of services provided in addition to direct information on asset management actions. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/02%3A_Asset_Management_Process/2.01%3A_Introduction.txt |
Commercial roofs represent a substantial asset that is often subject to an asset management process. Of course, roofs would only be one component of a building asset management process, but since roofs have special design characteristics, construction and maintenance, they often receive special attention. Figure 2.4 illustrates the various components of a typical low slope commercial roof. A reflective cap for energy conservation is the top layer, with a waterproof membrane, insulation (varying in thickness with design decisions relative to the local climate) and a roof deck below.
The goal of managing commercial roofs is often long term (or life cycle) cost minimization. In addition to roof maintenance and replacement costs, this cost minimization should consider user costs either directly or as a constraint (such as perform maintenance or replace if leaks begin to occur). A direct forecast of user costs would require assessment of the costs associated with roof failures (notably leaks) multiplied by the probability of such failures (Coffelt and Hendrickson 2010 and 2011). Introducing other goals for use of roof space or water retention might motivate adoption of different roof types, such as green roofs with a soil and plant layer (Blackhurst 2010).
Inventory of roofs is based upon building blueprints, maps, and inspection. A database record of a building roof characteristics and records is illustrated in Figure 2.5. The area of the roof is recorded as well as roof characteristics. The location of the roof can be found from the (unique) building name.
In this case, the roof has a record of manual inspections roughly every six months from 1997 to 2005. The inspection rated the condition of the overall roof, the membrane, the roof support and flashing using a five-point rating scale from 1 (new) to 5 (failed). Flashing is a metal strip to prevent water intrusion between a roof and another component such as a vent. In addition to roof inspection and rating, the biannual inspection can be used to perform minor maintenance such as clearing debris on the roof. Note that the roof was generally deteriorating in years 1997 to 2001, and then was in stable condition after the replacement of the old roof.
Inspection Date Overall Support Membrane Flashing Miscellaneous Asset Maintenance Asset Renewal
November 1997
March 1998
November 1998
March 1999
November 1999
March 2000
November 2000
March 2001
March 2002
March 2003
November 2003
March 2004
November 2004
March 2005
November 2005
5.50
4.00
4.50
4.00
3.50
2.00
2.50
2.50
6.00
4.50
5.50
5.50
3.50
4.50
4.00
6
6
6
6
6
6
6
6
6
6
6
6
6
6
6
5
4
4
3
3
2
2
1
6
6
6
6
4
5
6
6
4
5
5
4
2
3
4
6
3
5
5
3
4
2
6
6
6
6
4
5
5
5
6
6
6
5
6
5
5
\$
\$
\$
\$
\$
\$
\$
\$
2,778
836
852
196
194
852
242
1,200
95988
Figure 2.5 - Illustrative Database of a Commercial Roof Management System. Source: Don Coffelt – Carnegie Mellon University Asset Management System
In any particular year, the roof asset manager would review the roof condition, forecast roof conditions and costs for the next year or so, formulate alternatives (such as replace the roof or perform maintenance as recorded in the data record) and make decisions about treatments to the roof.
Performance monitoring could also be accomplished annually as the roof asset manager evaluates last year’s decisions.
Roof asset management has the advantage of reducing the risk of catastrophic losses that might occur with sudden roof failure. By systematically rating conditions and considering management alternatives, the roof asset manager avoids such failures. Of course, natural hazards such as tornados or hurricanes might still result in roof failures, but even there design decisions such as tying roofs down can reduce the risk of failure. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/02%3A_Asset_Management_Process/2.03%3A_Example_Asset_Management_System-_Commercial_Roof_Management.txt |
Asset management systems can focus upon improving condition, performance (often called level of service) or some combination of these characteristics. For infrastructure asset management, condition relates to the functionality of a particular infrastructure component and its deterioration process. Performance and level of service refer to the user experience and use of the infrastructure itself. Performance and level of service can also be defined and measured for processes that are not infrastructure, such as patient waiting time on visiting a hospital emergency room. Facilities management processes can also have process performance measures, such as response time and communications adequacy to repair requests.
Figure 2.6 illustrates levels of service for four different transportation modes as originally defined by the Florida Department of Transportation. The automobile level of service is usually defined by the volume of traffic relative to the roadway capacity. As volume increases, congestion and delay also increase with a progression from the level of service A (free-flow traffic) to F (traffic jam). For bicycles, the level of service is defined by the separation from the dangerous vehicular traffic stream. For pedestrians, sidewalk amenities, provision of sidewalks and separation from vehicular traffic influence level of service. For buses, the level of service is defined with respect to the frequency of service and crowding on the buses.
Individual components of infrastructure systems can also have level of service and performance measures. Figure 2.7 shows the levels of service for intersections with traffic signals defined by the California Department of Transportation. In this case, the level of service and performance is related to the average delay per vehicle at the intersection. Note that the factors affecting level of service relate to the intersection infrastructure (such as traffic signal and geometric conditions) as well as the traffic volumes (such as numbers of pedestrians and trucks).
Infrastructure performance can be a multi-dimensional consideration. For example, telephone service performance includes aspects of coverage (for cellular phones), dropped calls (again for cellular phones), sound quality and user costs.
For nearly all infrastructure systems, performance and level of service depend upon the infrastructure condition. For example, unreliable cellular telephone routers will degrade service performance. Leaky roofs are both a condition and a user problem. Rough and potholed roadway surfaces reduce the speed of traffic flow even at low traffic volumes. Moreover, the infrastructure conditions can be influenced directly by maintenance or rehabilitation activities initiated by an infrastructure manager, so the condition of infrastructure is often emphasized in infrastructure asset management.
The measures of infrastructure performance differ from system to system. Some typical performance measures would include:
• Asset condition assessed in processes of inspection and modeling of deterioration. Index scales are often used to summarize conditions as described in later chapters.
• Asset value is closely tied to condition as well as use.
• Cost for both owners and users of the infrastructure. Owner costs include
maintenance, operations, and rehabilitation. User costs include waiting or delay
times.
• Customer service related to communications and response to requests.
• Safety measured by the numbers and extent of injuries or risks.
• Reliability measured by the availability of infrastructure services both in normal
service and in extreme events such as hurricanes.
• Sustainability related to the overall economic impact of the infrastructure,
environmental emissions and resource consumption, and social impacts.
Fortunately, infrastructure managers can generally use organizational or well- established metrics of performance for asset management. Obtaining user costs can be more difficult, and may require special data collection efforts or surveys. For example, traveler delays on roadways may be assessed by measuring the speed of vehicles traveling over the network.
In later chapters, we will discuss the individual processes and approaches to condition assessment and infrastructure performance.
2.05: Chapter 2 Excercises
P2.1 (5 pts)
Suppose we decided to implement an asset management process for information technology in a small (100 people) office. What steps would be needed to do so?
P2.2 (10 pts)
Describe why asset management is such an important process for state and local authorities that are in charge of infrastructure. Be sure to consider economic and social impacts. Include references as needed.
P2.3 (10 pts)
Appearing below is Note 9 from the Carnegie Mellon University Annual Report for 2013.
1. Why would Carnegie Mellon go to the trouble of estimating the value of land, buildings and equipment?
2. What has accumulated depreciation? What fraction of the value of buildings, moveable equipment, utilities, and leasehold improvements has been depreciated? Why isn’t land in the same category as these other assets?
3. Carnegie Mellon hasn’t sold a building in a very long time. How might these values be estimated?
2.06: Chapter 2 References
References
• Blackhurst, Michael, Chris Hendrickson, and H. Scott Matthews. "Cost-effectiveness of green roofs." Journal of Architectural Engineering 16, no. 4 (2010): 136-143.
• Coffelt, Donald P., Chris T. Hendrickson, and Sean T. Healey. "Inspection, condition assessment, and management decisions for commercial roof systems." Journal of Architectural Engineering 16.3 (2009): 94-99.
• Coffelt, Donald P., and Chris T. Hendrickson. "Life-cycle costs of commercial roof systems." Journal of Architectural Engineering 16.1 (2010): 29-36.
• Coffelt Jr, Donald P., and Chris T. Hendrickson. "Case study of occupant costs in roof management." Journal of Architectural Engineering 18.4 (2011): 341-348.
• FHWA, Asset Management Primer, 1999, Federal Highway Administration, Washington, DC. http://www.fhwa.dot.gov/infrastructu...t/amprimer.pdf
• FHWA, Primer: GASB 34, 2000, FHWA, Washington, DC. isddc.dot.gov/OLPFiles/FHWA/010019.pdf
• Hendrickson, Chris and H. Scott Matthews, (2016), ‘Civil Systems Planning, Investment and Pricing,’ http://faculty.ce.cmu.edu/textbooks/cspbook/ (accessed May 10, 2016).
• NO, V., PERSON, C., NO, T., NO, F., & COURIER, P. O. (2006). ‘International Infrastructure Management Manual.’ Institute of Municipal Engineering of Southern Africa. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/02%3A_Asset_Management_Process/2.04%3A_Asset_Condition_Level_of_Service_and_Performance.txt |
As discussed in Chapter 2 Asset Management, asset component inventory and condition assessment are important steps in any infrastructure management process. They provide essential information for maintenance and rehabilitation decision making.
For immobile and long-lasting physical assets with explicit geophysical locations, inventory can be relatively simple. Data records for asset location, size, age and other pertinent information can be created. As new assets are added or retired, the data records need to be updated, either as transactions occur or on a periodic basis. Computerized asset facilities management (CAFM) systems and computerized maintenance management systems (CMMS) systems with or without mapping capability are often useful for these inventories.
For linear and network physical assets (e.g., pipelines, electrical distribution systems, etc.) inventory is increasingly complex. Like fixed location systems, data records can be created and updated; however, accurate inventories for the systems are specifically dependent on management systems with geospatial capabilities (e.g., geographic information systems (GIS)) that include a mapping capability so that these assets can be displayed on a two, or even three-dimensional map.
Mobile assets may be more difficult to inventory since their locations might not be known at any given time. However, records of acquiring and retiring mobile assets provide a means of keeping an inventory listing. Manual inspection or bar code readers provide a means of identifying the locations of the various assets. Figure 3.1 illustrates a typical mobile asset in the form of a postal truck used for carrying mail and parcels. Replacement parts for infrastructure such as elevators represent another class of potentially mobile assets that might be inventoried by an infrastructure manager.
3.02: Manual Inspection and Condition Assessment of Infrastructure
Manual inspection and condition assessment of infrastructure components is a common practice. These inspections require a knowledgeable individual and can include visual inspection, hearing (for motor sounds for example) and touch.
Good manual inspections have a defined rubric and a focus on completeness and consistency of condition assessment. A rubric is a guide for condition assessment based upon a set of rules or text descriptions. A wide variety of rubrics for infrastructure components exists. Figure 3.2 summarizes a rubric for pavement condition assessment as an example. In addition to this pavement condition assessment, other considerations for conditions might be skid resistance and structural capacity. Chapter 2, presents the results of a series of roof inspections with indices for roof components and an overall condition assessment.
Manual inspectors usually compare and discuss their results as a means of inculcating consistency and accuracy in condition assessments. For some types of inspections, formal classes and certifications may be required, such as the certification required for roadway bridge inspections.
Numerical indexes for condition assessment are also common, as with the .1 to 5.0 scale shown in Figure 3.2. Integer indexes are the most common for manual inspections. However, there is no consistency in the range of defined ratings among different infrastructure systems: inspectors may employ 0 to 3, 1 to 5, 1 to 10 and others. The best ratings also differ, with some systems having higher numbers for better conditions (as in Figure 3.2) and some indexes having lower numbers for better conditions.
Through the application of various manual rating systems condition indices, the following general guidelines emerge with respect to condition indices: it is difficult to differentiate between more than 7 condition states; a condition state of zero (0) may cause difficulties in derivative calculations; rating systems that equate a higher value with a better condition tend to graph more intuitively. Regardless, users of condition indexes should always check the index definitions to avoid misinterpretation of conditions!
Numerical condition indexes are often used in deterioration models as discussed in Chapter 3. They are also useful for developing comparisons and metrics of overall infrastructure conditions. For example, Figure 3.3 shows a map of pavement conditions in a region of central Massachusetts.
While condition assessments are usually numerical, they may also take the form of a condition grade, such as the scale A – excellent; B – very good; C – good; D – passable and F – failing.
Infrastructure ‘grades’ are also regularly prepared, but they generally involve a broader range of considerations than a simple condition assessment. These grades might include functional compliance with particular goals, adequacy of capacity relative to demand, infrastructure resilience and other considerations as well as the infrastructure condition. As an example, the criteria used in assigning infrastructure grades by the American Society of Civil Engineers (2016) includes condition rating but a variety of other criteria:
• Capacity – Evaluate the infrastructure’s capacity to meet current and future demands.
• Condition – Evaluate the infrastructure’s existing or near-future physical condition.
• Funding – Evaluate the current level of funding (from all levels of government) for the infrastructure category and compare it to the estimated funding need.
• Future Need – Evaluate the cost to improve the infrastructure and determine if future funding prospects will be able to meet the need.
• Operation and Maintenance – Evaluate the owners’ ability to operate and maintain the infrastructure properly and determine that the infrastructure is in compliance with government regulations.
• Public Safety – Evaluate to what extent the public’s safety is jeopardized by the condition of the infrastructure and what the consequences of failure may be.
• Resilience – Evaluate the infrastructure system’s capability to prevent or protect
against significant multi-hazard threats and incidents and the ability to expeditiously recover and reconstitute critical services with minimum damage to public safety and health, the economy, and national security.
• Innovation – Evaluate the implementation and strategic use of innovative techniques and delivery methods.
3.03: Devices to Aid Manual Inspection
The previous section outlined procedures for conducting manual inspections of infrastructure components. There are a variety of devices that can be used to aid such manual inspections.
Rulers and gauges are often useful for measuring lengths and depths of components or cracks. Mobile (battery) powered drills, wrenches and wire brushes also can be useful.
Devices to aid visual inspection in difficult or impossible to reach vantage points can be particularly useful. Hand-held mirrors and lamps are a simple example of such aid, but devices that are more elaborate exist. Figure 3.4 shows a video camera that suited for use in a small pipe that can provide pictures of the interiors so that corrosion or root intrusions may be identified. More elaborate pipeline ‘pigs’ can be stabilized in the desired location within the pipe and can have self-locomotion.
Unmanned flying vehicles (commonly called ‘drones’) provide another means of aiding manual inspections (Figure 3.5). These devices can simplify inspection of a variety of infrastructure components such as bridges or power lines. Drones are regulated for safety reasons and inspectors using such devices must determine the acceptable use of drones in any particular location. In addition to unmanned flying devices, underwater aids for visual inspection are also available, but visibility for such devices may be an issue. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/03%3A_Inventory_Inspection_and_Condition_Assessment/3.01%3A_Introduction.txt |
A variety of tests can also be used to assist or to replace manual inspection. For example, infrared images may be obtained to aid roof inspection, with areas of high heat flux indicating insulation issues. Water samples can be tested for a variety of trace elements. These test results can be considered in arriving at a particular condition assessment rating.
An example of an automated, sensor-based condition assessment is the widely used International Roughness Index (IRI) for pavements. This index is based upon the vertical variation on a pavement surface over a particular length of the pavement. More vertical variation represents rougher and worse condition pavement. The International Roughness Index is calculated from laser depth measurements and reported in units of length (of vertical variation) divided by length of measurement, such as millimeters per meter. Figure 3.6 shows the typical International Roughness Index values for different types of pavements and for different pavement distress types. Also shown in Figure 3.6 is a typical use speed for pavements of different conditions.
For an automated index such as the International Roughness Index, a manager would like to know how the index might compare to manual inspections and how the index might correlate to user costs (or in this case, traveler comfort). Fortunately, for the International Roughness Index there is good correlation with both manual inspections and reported ride quality as long as roughness measurements are made for the full width of the pavement surface.
Other automated approaches for pavement condition assessment are also possible. In particular, video images of pavement surfaces can be analyzed by software for a direct condition assessment. These methods make use of less expensive sensors in the form of video cameras and rely on pattern recognition approaches for pavement distress. In many cases, a combination of different approaches can be employed, with manual inspection often used for maintenance alternatives assessment.
A variety of other non-destructive sensors can be used for infrastructure component inspection. Visual inspection is described above, but others can include: Liquid Penetrant, Magnetic, Ultrasonic, Eddy Current and X-ray sensors. Figure 3.7 illustrates the use of ultrasonic sensors for identifying potential structural flaws hidden within a component such as a steel building beam or rail.
We will close with a few examples of devices and sensors used for different types of infrastructure inspections.
• Power plant equipment and facilities can be visually inspected, but hard to reach elements and corrosion identification require special sensors. Eddy current probes, crawling robots and flying drones may all help inspectors.
• Periodic wire rope inspection for aerial lifts and transmission lines is always recommended (and often required by regulation). While visual inspection is the traditional method of inspection, drones, measuring devices and sensors for internal flaws can all be used.
• Storage tank inspection is routinely performed. Above ground, tanks can be observed manually, with crawlers or with drones. Below-ground tanks can be inspected from the inside (as with pipes), but exterior inspection below ground is difficult.
• Rail inspection can be performed manually, but specialized sensors are usually employed to assess geometry or hidden defects. Dedicated vehicles are commonly used, but there is already equipment available that can monitor rail conditions from regularly running trains.
• Natural gas leaks have specialized sensors that may be handheld or designed for vehicles. Since natural gas (or methanol) is a potent greenhouse gas, a new emphasis on inspection for leak identification and repair is becoming more prevalent and important.
3.05: Chapter 3 Excercise
(5 pts)
What is best way to measure flow on a river every hour?
(5 pts)
What is the best way to estimate stormwater run-off from:
a. A building?
b. A neighborhood?
c. A city?
(15 pts)
Descriptions and color photos are attached at the end of this exercise section for seven types of asphalt pavement distress. Your assignment is to walk around the local area and identify as many of the seven types of pavement surface distress as you can. List a specific location for each type you find, describe the distress, including an estimate of the size of the distressed area, and either take a photograph or produce a sketch of the distress. You may do this problem with one or more colleagues.
Important Note: Watch out for traffic! Work during daylight hours and do not expose yourself to traffic. Parking lots and sidewalks can be used for this exercise!
3.06: Pavement Distress Examples
Alligator Cracking
Block Cracking
Distortions
Distortions are usually caused by corrugations, bumps, sags, and shoving.
They are localized abrupt upward or downward displacements in the pavement surface, series of closely spaced ridges and valleys, or localized longitudinal displacements of the pavement surface.
Longitudinal and Transverse Cracking
Longitudinal cracks are parallel to the pavement’s centerline or laydown direction while transverse cracks are perpendicular.
Longitudinal cracks may be caused by poorly constructed paving lane joints, shrinkage of the asphalt concrete surface due to low temperature, or a reflective crack caused by joints and cracks beneath the surface course.
Patching and Utility Cut Patching
A patch is an area of pavement, which has been replaced with new material to repair the existing pavement. A patch is considered a defect no matter how well it is performing.
Rutting and Depressions
A rut is a depression in the wheel paths.
Rutting stems from a permanent deformation in any of the pavement layers or sub grade, usually caused by consolidated or lateral movement of the materials due to traffic loads.
Weathering and Raveling
Weathering and raveling are the wearing away of the pavement surface. This distress indicates that either the asphalt binder has hardened appreciably or that a poor quality mixture is present.
3.07: Chapter 3 References
References
• ASCE, American Society of Civil Engineers, 2013 Report Card for America’s Infrastructure. http://2013.infrastructurereportcard.org/ (accessed July 22, 2017).
• Coffelt, Donald P., Chris T. Hendrickson, and Sean T. Healey. "Inspection, condition assessment, and management decisions for commercial roof systems." Journal of Architectural Engineering 16.3 (2009): 94-99.
• FHWA, Federal Highway Administration, ‘2013 Conditions and Performance Report,’ Chapter 3: System Conditions, http://www.fhwa.dot.gov/policy/2013cpr/
• Sayers, M.W., Gillespie, T. D., and Paterson, W.D. Guidelines for the Conduct and Calibration of Road Roughness Measurements, World Bank Technical Paper No. 46, The World Bank, Washington DC, 1986 | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/03%3A_Inventory_Inspection_and_Condition_Assessment/3.04%3A_Sensors_for_Inspection_Condition_Assessment.txt |
As soon as infrastructure is newly built or rehabilitated, it begins to deteriorate. The decline in overall infrastructure condition may be slow, but it is inevitable. The decline may be mitigated by preventive maintenance or even reversed by major rehabilitation actions such as repaving, but deterioration will again proceed without continuing interventions that are likely to be expensive.
The common ‘Deterioration Hypothesis’ posits that infrastructure will deteriorate over time due to use and other factors. The strict form of the ‘Deterioration Hypothesis’ assumes that conditions cannot improve over time unless there is an intervention by infrastructure managers and workers. Typical factors causing deterioration are weathering, corrosion, use-related stress, and general wear-and-tear. Figure 4.1.1 illustrates the deterioration hypothesis with slow condition degradation for a period of time, then a more rapid deterioration as the infrastructure ages and its condition degrades. As shown in the figure, interventions for asset preservation can improve the asset condition rating, but the deterioration then resumes.
While the deterioration hypothesis is used for infrastructure components, it is also relevant and used for a variety of other devices. For example, paper may deteriorate due to insects, mold, fire, water damage, chemical reactions caused by light, wear-and-tear in use and other factors. Mechanical equipment is similar expected to deteriorate over time. For example, Figure 4.1.2 shows a worn car. In many cases, worn equipment must be replaced by regulatory requirements or owner decisions.
The choice of materials and quality of construction can slow the process of infrastructure deterioration. Similarly, favorable weather conditions can make even inevitable deterioration quite slow. For example, water penetration with freeze-thaw cycles in colder climates can result in more rapid occurrence of pavement cracking. Figure 4.1.3 shows the probability of acceptable quality (shown as ‘survival probability’) for bridge decks without rehabilitation work with different material, traffic and environmental conditions. As can be seen, the spread of survival probabilities over the different conditions is quite large.
As the condition of infrastructure declines, infrastructure managers must consider what steps (if any) should be taken to reverse the deterioration. Some decisions are relatively simple, such as intervening on structures in danger of collapse. More commonly, infrastructure managers make such decisions as part of the asset management process described earlier.
An important input into such decision making is the expectation of deterioration in the future if nothing is done to reverse the existing damage. Deterioration modeling is a process of taking condition assessment information (as described in Chapter 3) and forecasting expected future conditions.
Numerous approaches to deterioration modeling exist. In this chapter, we will briefly discuss the following approaches:
1. No deterioration modeling. Use existing conditions for decision making.
2. Extrapolation/Moving Average of conditions over time.
3. Regression Models based on statistical analysis.
4. Markov Models of probabilistic deterioration.
5. Semi-Markov Models of probabilistic deterioration
6. Neural Networks using an artificial intelligence approach based on a learning set of deterioration examples.
7. Failure Distributions and Fault Tree Analysis to assess the probability of failure.
In this discussion, our intent is to provide sufficient background for infrastructure managers to understand the different approaches, including their advantages and disadvantages. Where appropriate, references are provided for those wishing to delve more completely or deeper into particular approaches.
Finally, all of the deterioration modelling approaches noted above depend upon empirical data on component deterioration. Keeping such records is a critical asset management task!
4.02: Simple Decision Making and Forecasting from Condition Assessment
In many cases, asset management decisions are made without complicated deterioration models at all. The simplest approaches simply use the existing component condition, a linear projection of the component condition over time, or a projection based upon the past history of similar components (using a graph such as those illustrated in Figure 4.1.3). These approaches are discussed in this section.
Using the existing condition can be augmented with simple decision rules. For example, ‘if the condition is x or lower, then rehabilitation is desirable.’ Components with only two condition states defined are particularly amenable to this approach. For example, an incandescent light either works or is burnt out. The maintenance rule might be to only replace lights when they burn out.
A subset of this simplified method includes a “run to failure” approach. Unfortunately, this “fix it when it breaks approach” is a widely applied and expensive approach to infrastructure management. There are scenarios, like window air conditioners, when it simply doesn’t make sense to replace before failure. As we will explore, it is nearly always more cost-effective to replace before failure when considering major infrastructure systems.
Using existing conditions has the advantage of eliminating any costs associated with deterioration modelling. However, the amount of effort may fluctuate considerably as many components cross over the trigger condition for action and this may not be compatible with budget constraints. Also, if deterioration has significant costs, waiting until deterioration occurs may not be the best approach.
Simple linear extrapolation is another approach that is inexpensive to employ for deterioration models. In this approach, c where ct is the condition at time t, and Δt is some desired time period in the future.
\[c_{t+Δt} = c_t + (c_t - c_{t-1})\]
As an example, suppose the component condition is now 3, last year the condition was 4, then the forecast for next year is \(3 + (3-4)*1 = 3 – 1 = 2\) and the forecast for the following year (two years from now) would be \(3 + (3-4)*2 = 1\). More complicated forms of extrapolation could also be used, but linear extrapolation is the most common for infrastructure deterioration.
A single year maybe two short of a period to effectively capture deterioration, so a moving average of multiple years might be used instead. In this case, \(c_t\) would be the average condition for the current period of years (which might be the past three years). This approach would be useful for very slowly deteriorating infrastructure components. Moving averages of this type are common for smoothing fluctuating time series histories such as stock prices.
Finally, forecasts of component deterioration might be based upon simple historical records. For example, Figure 4.1.3 shows the average deterioration trajectory of different bridge decks under specific conditions. An infrastructure manager might assume that a particular bridge deck with a particular condition would simply follow this trajectory in the future. Even without a formal database, infrastructure managers might have their mental model of expected deterioration and make subjective forecasts based upon their experience. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.01%3A_Introduction.txt |
A more complicated approach to deterioration modelling than those in the previous section employs statistical approaches, most commonly regression analysis. These models are based upon observations of past history and conditions. The models can indicate the correlation between conditions and explanatory factors such as time and usage.
Statistical modelling is a topic of considerable interest and for which a large body of knowledge exists. In this section, we provide only the basic information that is useful for an infrastructure manager, not a researcher or expert modeler. Other works can be consulted, such as the variety of books recommended by the University of California, Berkeley, Statistics Department:
sgsa.berkeley.edu/current-stu...ommended-books
There are also a variety of software programs that can be used for statistical modelling, including add-ins to spreadsheets such as Microsoft Excel, general modelling environments such as MATLAB, or programs focused on statistical modelling such as R, S, Minitab or Statistical Package for the Social Sciences (SPSS). Any of these software programs can be used for infrastructure deterioration modelling since the data usually available for deterioration modelling are well within the capabilities of any of these software programs. Also, these programs typically provide help files and tutorials that can be consulted.
For deterioration models, the dependent variable is typically condition expressed as a numerical index. Explanatory variables may be time (such as age in years since last rehabilitation), usage, weather zone and others. Different deterioration models may be estimated for different component designs, such as pavement characteristics, or these characteristics may be added. For example, a simple linear condition model might be:
$c=\alpha+\beta *(a g e)+\epsilon$
where c is a condition index (such as a scale of 1 to 10), $\alpha$ and $\beta$ are coefficients to be estimated and $\epsilon$ is a model error term. A series of observations of c and age would be assembled as input data for estimation. Then, a software routine could be employed to estimate the appropriate values of the coefficients $\alpha$ and $\beta$ for the estimated model. In these routines, the coefficients $\alpha$ and $\beta$ are calculated to minimize the sum of squared deviations between condition and the model forecast (represented by the $\epsilon$ values).
Equation 4.3.1 shows a linear deterioration model, meaning that the explanatory variable age is linearly related to the dependent variable condition index. Additional explanatory variables could be added to the model, each with a coefficient to be estimated. Also, non-linear model forms can be used, such as a quadratic model where age enters as both a linear and a squared explanatory variable:
$c=\alpha+\beta_{1} *(a g e)+\beta_{2} *(a g e)^{2}+\epsilon$
Another common model form is an exponential model form:
$c=\alpha *(a g e)^{\beta}$
This exponential model is often linearized for estimation purposes by taking the logarithm of both sides of the equation to form a linear model with respect to the coefficients to be estimated:
$\ln (c)=\alpha^{\prime}+\beta *(a g e)+\epsilon$
Where $\alpha '$ is the logarithm (in function) of α in Equation 4.3.2. In this linear form, the input data for estimation would be $ln(c)$ and age.
Which model form should be chosen for use in any particular case? Generally speaking, simple forms are preferable to more complicated forms. Also, model forms that correspond to reasonable deterioration causes are preferable. For example, desirable pavement deterioration model forms would include both deteriorations over time and for different levels of vehicle usage.
As an example, Morous (2011) estimated a polynomial model of bridge deck deterioration in Nebraska based simply on bridge deck age. The estimated model was:
y=10-0.25 * x+0.0093 * x^{2}-0.0001 * x^{3}
$y=10-0.25 * x+0.0093 * x^{2}-0.0001 * x^{3}$
where y is condition rating (c in Eq. 4.1-4.4) and x is age (or age in Eq. 4.2.1, 4.3.1-4.3.3). As can be seen in Fig. 4.3.1, the polynomial model is close to the historical data on bridge deterioration. Morous (2011) also reports the R2 value of the estimated regression equation (equal to .99 in Figure 4.4) which is a measure of ‘goodness of fit’ of the model to the data. In this case, 99% of the variation in the dependent variable is captured by the regression model.
The usefulness of regression deterioration models really derives from situations in which multiple explanatory factors are of interest, such as age, pavement type and vehicle usage (generally measured in equivalent standard axle loads) for roadway pavements or bridge decks. For the model shown in Fig. 4.4, the use of historical data or the regression model has the same forecasting ability. But with more factors considered, two-dimensional graphical representations such as Fig. 4.4 cannot be used directly.
Regression approaches typically make fairly heroic assumptions about the available data and appropriate model forms. In particular, the values of the error term ε in Equations Eq. 4.2.1, 4.3.1, and 4.3.2 are generally assumed to be normally distributed with mean zero, independent of each other and with a constant variance. It is unlikely that any deterioration models fulfill these formal assumptions exactly. If nothing else, condition ratings typically are constrained to be positive, so highly negative values of ε are not allowed. Moreover, historical observations of components are unlikely to be completely independent. Fortunately, regression deterioration models are usually fairly robust, so deviation from the formal assumptions is not a practical problem to obtain reasonable coefficient estimates. However, factors such as correlated error terms make the use of formal statistical testing approaches problematic.
Forecasts from regression models are uncertain, as is the case for all deterioration models. Based on past histories and distribution assumptions, it is possible to estimate confidence intervals for forecast values. Figure 4.3.2 provides an example, with confidence intervals for Australian tax receipts shown, where a 90% confidence interval suggests that the forecast receipts will fall within the interval 90% of the time. The 90% confidence interval in this case for the following year is from 18 to 22.5 as a percent of Australian Gross Domestic Product (GDP). Developing formal confidence intervals would be unusual for infrastructure management, but the managers themselves should always be aware that the actual outcomes will likely differ from forecasts. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.03%3A_Regression_Models.txt |
Markov deterioration models are used in numerous asset management software programs. Markov models can readily accommodate the use of condition indexes with integer values and deterioration estimation for discrete-time periods such as a year or a decade. As a result, Markov models can be combined with typical condition assessment techniques and budgeting processes.
Markov models are stochastic processes with forecast probabilities of transitions among different states ($x$, where $x$ is a vector of multiple potential states) at particular times $(t)$ or $x(t)$. Markov models of this type are often called ‘Markov chains’ to emphasize the transitions among states. For infrastructure component models, the states are usually assumed to be different condition indexes. If a component is in some particular condition state ($x_i$) then it might stay in that condition or deteriorate in the next year. Figure 4.4.1 illustrates a process with just three defined condition states (1 – good, 2 – intermediate, 3 – bad condition). If the condition at the beginning of the year is state 2 (intermediate), then the Markov process shows a 0.8 probability or 80% chance of remaining in the same condition and a 0.2 probability or 20% chance of deteriorating to state 3. If the component begins in state 3 (bad or poor condition), then there is no chance of improvement (or a 100% chance of remaining in the same state). State 3 is an ‘absorbing state’ since there is no chance of a transition out of state 3.
The Markov process in Figure 4.4.1 illustrates the pure deterioration hypothesis, in that the component cannot improve the condition over time. Beginning in state 1, the component could deteriorate to state 3 within two years and then remain permanently in state 3. More likely, the component would stay in state 1 or state 2 for a number of years, and the deterioration to state 3 would take multiple years. Note that the transition probabilities do not change over time, so the Markov model assumes that the time spent in any state does not increase the probability of deterioration (this is often called the ‘memory-less property’ of Markov models).
A Markov process may be shown in graphic form as in Figure 4.5.1 or as a table or matrix of transition probabilities. Formally, the state vector is x = (1, 2, 3) and the transition matrix P has three rows and three columns corresponding to the last three columns and bottom three rows in Table 4.1.1 (as shown in Figure 4.5.2). Note that the rows of the transition matrix must sum to 1.0 to properly represent probabilities.
Table $1$: Transition Probabilities for the Three State Process in Figure 4.5.1
State To: 1 2 3
From:
1 0.8 0.2 0.0
2 0.0 0.8 0.2
3 0.0 0.0 1.0
What happens if the infrastructure manager adopts the policy that components in state 3 will always be rehabilitated to state 1? In this case of intervention, there would be a transition from state 3 to state 1 with a 1.0 probability. The Forecasting conditions (or more precisely, forecasting the probability of particular states) with a Markov model involves the application of linear matrix algebra. In particular, a one-period forecast takes the existing state probabilities in period $n$, $\pi_n$, and multiplies the transition probability matrix:
$\pi_{n+1}=\pi_{n} * P$
The forecast calculation may be continued for as many periods as you like. A forecast from period $n$ to period $m$ would be:
$\pi_{n+m}=\pi_{n} * P^{m-n} \label{4.3.1}$
Using Eq. \ref{4.3.1}, a forecast two periods from now would multiply $\pi_n$ by $P*P$. Figure 4.4.2 illustrates the calculations for a two-period forecast using the transition probabilities in Table 4.4.1 and assuming the initial condition is state 1 (good). While it is possible to transition from good condition to bad condition in two periods, the probability of deteriorating this quickly is only 0.04 or 4%. Most likely, the component would remain in good condition for two periods, with probability 0.64 or 64%. As a check on the calculations, note that the forecast probabilities sum to one: $0.64 + 0.32 + 0.04 = 1.0$.
The procedure shown in Figure 4.5.2 can be extended to find the median time until component failure. By continuing to forecast further into the future (by multiplying $\pi$ by P repeatedly), the probability of entering the absorbing state 3 will increase. The median time until entering this state is identified when the probability reaches 0.5 or 50%. It is also possible to calculate the expected or mean time before component failure analytically. However, the median time is likely of more use in planning maintenance and rehabilitation activities for a large number of infrastructure components.
Numerous software programs can be used to perform the matrix algebra calculations illustrated in Figure 4.5.2. Two popular programs that have matrix algebra functions provided are the spreadsheet program EXCEL and the numerical analysis program MATLAB.
Where would an infrastructure manager obtain transition probability estimates such as those in Table 4.4.1? The most common approach is to create a historical record of conditions and year to year deterioration as described in Chapter 3: Condition Assessment or illustrated in Figure 4.1.3. Historical records could give the frequency of deterioration for a particular type of component and for a particular situation. Expert, subjective judgments might also be used, but these expert judgments are informed by analysis or observation of such deterioration over time.
Finally, we have presented in this section the simplest form of Markov process modelling. We have done so because this simple form seems to be useful for infrastructure management, with many Markov process applications for components such as roadways or bridges. A variety of extensions or variations are possible:
• Rather than discrete annual steps being modelling, a Markov model may use continuous time. In this case, the transition probabilities are modelled as a negative exponential probability distribution.
• If the ‘memoryless’ property of the simple Markov model seems unacceptable, you can adopt a semi-Markov assumption or even augment the state space to include both conditions and age in condition states. Unfortunately, the resulting models become more complicated and require more data for accurate estimation.
Readers wishing a broader and more mathematically rigorous presentation of Markov processes should consult a book such as Grimstead and Snell (2012) which is available for free download on the internet.
4.05: Artificial Neural Network Deterioration Models
Artificial Neural networks can serve as an alternative to regression or Markov deterioration models. They are based upon an analogy to how simple biological brains behave in transmitting signals among individual neural cells. They originated in work on artificial intelligence and machine learning.
Figure 4.5.1 illustrates a neural network. Inputs might be condition index values, age or weather effects. Outputs might be probabilities of transitioning to particular conditions over the course of a year. Figure 4.5.1 illustrates the signal processing that would be occurring within each of the artificial neurons (represented as circles in Figure 4.5.1). The input signals are weighted, combined and transformed into an output activation.
Artificial neural networks are typically ‘trained’ with a learning set. For a deterioration model, inputs might consist of conditions (and other relevant factors) in the base year and the training outputs would be the observed conditions in the following year. Training consists of altering parameters (such as the weights in Figure 4.5.2) to best reproduce the results observed in the training set.
Artificial neural networks are not frequently used for component deterioration modelling. One drawback to their use is the ‘black box’ nature of the results where the various weights and activation functions are difficult to interpret (or even obtain). Also, artificial neural networks typically have many more parameters than other types of models, requiring more data to be robust.
Infrastructure managers are more likely to encounter artificial neural networks in conjunction with sensor interpretation. For example, artificial neural networks can be used to identify vehicles or pavement distress from video inputs. Figure 4.5.3 illustrates a video-based system for vehicle identification. A frame from the camera is divided into a two dimensional set of tiles within a pre-defined detection zone and the color and brightness of the pixels within each tile are input to an artificial neural network vehicle detector model. A training set of images with and without vehicles is used to adjust parameters in the detector model. In turn, traffic identification of this type can be used in a deterioration model for pavement condition.
A detection sequence for the video vehicle identification is illustrated in Figure 4.5.4. As the vehicle moves through the detection zone, counting output is activated for each part of the zone. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.04%3A_Markov_Deterioration_Models.txt |
In addition to deterioration models linked to component condition indexes, deterioration models may also be expressed as probabilities of failure (or survival as the inverse of failure) at different points of time. Of course, difficulty in using this approach for infrastructure components is to define what constitutes ‘failure.’ For a mechanical device such as an elevator, failure might be simply regarded as ceasing to work. For a roadway pavement, the pavement might be considered to have failed when a desired level of service is not provided, even though the roadway may still be passable at low speed.
Failure rates are defined as the likelihood of failure in the next time interval assuming that the component has not failed up until the present time. The failure rate typically is larger than the failure density function since the component has survived for one or more periods. Since infrastructure managers are concerned with forecasting the possibility of failure in the next period or two for decision making, the failure rate is generally of more interest rather than the direct probability of failure of a component at any given time in the future. We will use a numerical example to illustrate failure rates, survival probability and failure probabilities using the data shown in Table 4.6.1.
Table 4.6.1: Numerical Illustration of Failure and Survival Probabilities and Failure Rates
Period (Year) Probability of Failure in Period $f(t)$ Cumulative Probability of Failure $F(t)$ Cumulative Probability of Survival $R(t)$ Failure Rate in Period $\lambda(t)$
1 0.10 0.10 0.90 0.100
2 0.02 0.12 0.88 0.022
3 0.02 0.14 0.86 0.023
4 0.02 0.16 0.84 0.023
5 0.02 0.18 0.82 0.024
6 0.02 0.20 0.80 0.024
7 0.10 0.30 0.70 0.125
8 0.20 0.50 0.50 0.286
9 0.20 0.70 0.30 0.400
10 0.30 1.0 0.00 1.000
Cumulative Probability of Failure $F(t)$ is $F(t-1) + f(t)$. Cumulative Probability of Survival R is $1 - F(t)$. Failure rate $\lambda(t)$ is $\frac{f(t)}{R(t)}$ or $R(t) - \frac{R(t-1)}{R(t)}$ .
Table 4.6.1 illustrates a component that is in good condition at the present but is expected to certainly fail after ten years of use. The probability of failure f(t) (Column 2) represents an estimate of failure in each period, with a 10% of failure immediately (during a break-in period), a period of low probability of failure in years 2-6 (regular use) and then an increasing probability of failure in years 8 to 10 (wearing out). The cumulative probability of failure $F(t)$ is the sum of failure probabilities for period $t$ and previous periods. It begins at zero and increases steadily to 1.0 (certain failure) by year 10. Cumulative probability of survival $R(t)$ is the inverse of the cumulative probability of failure, $1 – F(t)$. The failure rate $\lambda(t)$can be calculated as:
$\lambda(t)=\frac{f(t)}{R(t)}=R(t)-\frac{R(t-1)}{R(t)}$
It has a value of 0.1 in period 1, reflecting the possibility of failure during the break-in period. After this, the failure rate is relatively low but increasing slowly. During the final wear our period, the failure rate increases substantially. Note that the sum of the failure rates during all periods is in excess of 1, so the failure rate is not a probability. However, for decision making, an infrastructure manager would find it helpful to know in year 5 that the risk of failure in the next period is small (0.024). However, in year 8, while the component still may be working, the risk of failure in the next period is substantial (0.400). The pattern of the failure probabilities and rates in Table 4.4.1 is common for infrastructure components and often called a ‘bathtub shape’ as illustrated in Figure 4.6.1 below.
Initial break in use of a component often reveals design or fabrication flaws that may cause failure. After this break-in period, a (hopefully lengthy) period of regular use and low failure risk occurs. As the component wears out, the risk of failure increases. Figures 4.6.2 and 4.6.3 further illustrate these periods graphically for failure probability and cumulative probabilities.
The numerical example presented above did not assume any particular distributional form for the failure probabilities. However, many applications of failure models assume some particular distribution and use historical data to estimate the parameters of the distribution. We will discuss two distributions used in this fashion: the exponential and Weibull distributions.
The form of the exponential failure model for the the cumulative probability of failure is:
$F(t)=\int_{0}^{t} \alpha * e^{-\alpha t} d t=1-e^{-\alpha t}$
Which is the integral from 0 to time $t$ of the parameter α times exponential of $-\alpha * t$ or, more simply, one minus the exponential of $-\alpha * t$. The probability density function of failure for the exponential distributions is $\alpha * e^{-\alpha t}$ . The exponential function has only one parameter ($\alpha$ in this notation) and the average time to failure is the reciprocal of this parameter ($\frac{1}{\alpha}$). The failure rate is constant over time with a value of the parameter α (calculated from Eq. 4.6.2 as $\alpha*\frac{e^{-\alpha t} }{e^{-\alpha t}} = \alpha$. With the negative sign in the cumulative and density failure distributions, the exponential function is often referred to as a ‘negative exponential distribution.’
Figures 4.6.4 and 4.6.5 illustrate the form of the exponential function for different parameter values. The cumulative failure probability increases relatively rapidly initially (except for low values of the parameter $\alpha$ continues to slowly increase for a long period of time.
Estimation of the parameter $\alpha$ is relatively simple in practice. Given a set of component failure observations, the parameter α is the inverse of the average time until failure observed in the sample.
A second distribution often assumed for failure models is the Weibull or ‘extreme events’ distribution. The term ‘extreme events’ reflects the use of the Weibull distribution for modelling events such as the probability of earthquakes or hurricane wind speeds. It also reflects the notion that the distribution returns the probability of the most extreme value obtained from a series of random variable results. For infrastructure components involving a large number of pieces that might fail, this analogy is appropriate. The distribution is named for Wallodi Weibull, a Swedish engineer, and mathematician who lived in the twentieth century.
The general form of the Weibull distribution includes three parameters. Using the notation of NIST (2016), the parameters are $\mu$ (called the location parameter), $\gamma$ (called the shape parameter) and $\alpha$ (called the scale parameter). The failure probability density function is shown below, with $x$ representing time:
$f(x)=\frac{\lambda}{\alpha}\left(\frac{x-\mu}{\alpha}\right)^{(\lambda-1)} e^{\left(-\left(\frac{x-\mu}{\alpha}\right)^{\lambda}\right)} \text { where } x \geq \mu ; \lambda, \alpha>0$
Simpler forms of the Weibull distribution function may be obtained by assuming values of the location parameter (such as $\mu = 0$) and the scale parameter (such as $alpha = 1$). Thus, one, two or three parameter forms can be obtained.
With different values of the three parameters, a wide variety of distributional forms may be obtained. Figure 4.6.6 illustrates the effects of different values of just the shape parameter. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.06%3A_Failure_Rates_and_Survival_Probabilities.txt |
The previous section described various models of component failure forecasting. Fault trees are used to forecast the failure probability of a system of components based upon the likelihood of component failures. Fault trees provide a means of identifying weaknesses in systems and allowing managers to make changes to reduce the risk of failure.
Fault trees begin with a top node representing the condition of the entire system. Causes for system failure are then deve4loped as a series of events and subcomponents that may cause failures. Multiple layers of subcomponents may be included. Figure 4.7.1 illustrates a simple fault tree with three layers and eight different elements.
As an example, suppose an infrastructure manager is tasked with ensuring electricity is available in a building at all times. The manager invests in a back-up generator in case the grid electricity fails. In this case, the building might not have electricity if the grid fails and the back-up generator fails to start. In any given day, if there is a 1% chance (0.01 probability) that the power grid may fail and a 5% chance (0.05 probability) that the back-up generators fails, then there is a 0.0005 or 0.05% chance that electricity will fail. This is an example in which the redundancy of power sources reduces the chances of not having power for the building. A further step of analysis might be to examine reasons for failure of the back-up generator such as lack of fuel or damage to wiring. Also, a manager might set up a regular inspection regime for the back-up generator to attempt to reduce its 5% chance of failure.
This electric power provision is an example of redundancy with an ‘and’ node: both the power grid and the backup generator must fail for the system to fail. Unfortunately, system failures might also occur if any one of a number of events occurs. This is would be an ‘or’ node. For example, a ladder would fail if either of the two vertical supports failed. If the probability that a vertical support fails is 1% (0.01 probability) in normal use, then the probability of success is 0.99. There are four cases that might arise from use:
1. Both vertical supports work with probability 0.99*0.99 = 0.9801
2. Left support breaks and right support does not fail, but ladder as a system fails with probability 0.01*0.99 = 0.0099
3. Right support breaks and left support does not fail, but ladder as a system fails with probability 0.01*0.99 = 0.0099
4. Both vertical supports fail and the ladder system fails with probability 0.01*0.01 = 0.0001
With a ‘or’ node relationships (multiple potential causes of failure), the probability of failure can be calculated as:
$\text { Pr \{ failure } \}=\Sigma_{i}\{1-\mathrm{~ P r ~ ( s u b c o m p o n e n t ~ i ~ f a i l u r e ) \} ~}$
Where the summation $\Sigma$ is taken over all the subcomponents included in the ‘or’ node level.
A common convention in drawing fault tree networks is to represent ‘or’ gate relationships with a curve at the bottom (as in the top gate in figure 4.6.6) and an ‘and’ gate relationship with a straight bottom (as in the bottom gate for events 7 and 8 in Figure 4.6.6). The failure probability of the system in Figure 4.6.6 would then be traced through the three ‘or’ gates and the two ‘and’ gates:
$\mathrm{~ P r \{ S y s t e m ~ F i g . ~ 4 . x ~ f a i l u r e \} ~}=[1- (1-Prelevent 1 failure))*(1-Pr[event 2 failure]] + \text { Pr\{event }3 \mathrm{~ f a i l u r e \} * P r \{ e v e n t ~} 4 \text { failure }\} \text { 'Prievent } 5 \text { failure }\}+ \left[1-(1-\text { Prievent } 6 \text { failure }\}^{*}(1-\text { Pr fevent } 7 \text { failure }\}^{*} \text { Pr } \text { [event } 8 \text { failure }\right] ] Eq.$
More complicated relationship gates can be defined (such as exclusive ‘or’ gates), but they are not widely used for any infrastructure failure models. These more complicated relationships can find use in fault tree analysis of circuits or computer operating systems.
A complication in the calculation of failure probabilities shown above will occur when failures are correlated in some fashion. For example, flooding might cause both the power grid and the backup generator to fail in the electric power example above. In this case, the straightforward probability of the backup generator failing, Pr{failure backup generator} would be replaced with the probability of failure of the backup generator conditional on the power grid failure: Pr{failure backup generator │ failure power grid}. Of course, a prudent infrastructure manager might insure that the backup generator is protected from floods, so this chance of system failure due to flooding would disappear.
Another difficulty for fault tree analysis for infrastructure is that some systems may not fail completely but may degrade in performance. For example, a roof may start to leak rather than fail completely. For such cases, separate degradation states can be defined and fault trees developed for each level of degradation.
Fault tree analysis is fairly labor-intensive and it is difficult to be comprehensive about potential failure modes. However, the conceptual process of identifying failure causes and events can be helpful in managing the reliability of infrastructure systems. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.07%3A_Fault_Tree_Analysis.txt |
P4.1 (4 pts)
Many classrooms are equipped with video projectors that can be connected to portable, laptop computers for use during class meetings.
a. Based upon your experience with such systems, what is the probability of projection system failure over the course of a year of regular classes in such a room?
b. Develop a fault tree of potential causes for a classroom video projection system.
P4.2 (8 pts)
Appearing below is a series of roof inspection condition summaries, where 1 is excellent and 5 is poor. Note that an inspection 1997.5 occurred in the second six months of 1997, whereas 1997 occurred in the first six months of 1997. The roof was replaced in 1985. Answer the questions below. You might use software aids, such as EXCEL or MATLAB, for this problem.
DATE CONDITION
1985 1
1985.5 1
186.5 2
1997 2
1997.5 2
1998 2
1998.5 2
1999 3
1999.5 3
2000 4
2000.5 4
2001 4
2002 4
2002.5 4
2003 5
a. Estimate an ordinary least squares regression deterioration model of the form: Condition = $a + b(age)$ where age is the age of the roof in years. Report your parameter estimates, standard errors, t-statistics, and $R^2$ values. Note that there is a gap in the data from 1985 to 1996!
b. Suppose I have a comparable roof that is 12 years old. What would your regression model in (a) predict for its condition? What would it predict for age 18? At what age is the condition expected to become 5?
c. Plot the data and your regression line.
d. Do you think a non-linear regression model would fit the data better? Try a quadratic model (Condition = $a + b(age) + c(age^2)$ and an exponential model (Condition = $a*age^b$) and discuss your results. Which model has a better-adjusted $R^2$? Which model would you use in practice for deterioration prediction?
P4.3 (16 pts)
Formulate a simple Markov process model of roof condition. Assume that transitions occur every six months and can either be a return to current condition or a transition to the next worse condition (except for state 5 which is an absorbing state without an exit in this deterioration model…)
a. Draw your process model as a series of states (in circles) and transition possibilities (as arrows) for five states corresponding to roof conditions 1 to 5.
b. Assume the probability of remaining in state 1 is 0.93 in any one transition. Estimate (from the data above) or calculate (when appropriate) the remaining transition probabilities and mark them on your process diagram.
c. Develop a Markov transition matrix for your process.
d. Suppose you start at time 0 in state 1. Calculate the probability of being in each state for the next twenty years (or 40 transitions) based on your model.
e. Suppose you believe that a roof must be replaced when the roof condition reaches state 5. Starting with a new roof (state 1 in time 0), plot the probability of being in state 5 as a function of time.
f. Calculate the expected service time of the roof based on your data in part e. You can assume that the expected service time is when the probability of entering state 5 reaches 50%.
g. If you ran your model to the limit (infinite time), what is the probability of being in each state?
h. How does your Markov process model compare with your linear regression model in Question 1? In particular, is the expected service time different? Is the Markov model non-linear? Why or why not? Which is preferable and why?
P4.4 (6 pts)
Suppose I have the simple piping system shown below:
For this simple system, I develop a fault tree for failure analysis as:
Suppose further that the estimated failure probabilities of the four sub-events are independent and are as follows (left to right in the figure):
Event D empty A broken B blocked C blocked
Event Probability 0.15 0.05 0.1 0.1
P4.1 (4 pts)
Many classrooms are equipped with video projectors that can be connected to portable, laptop computers for use during class meetings.
a. Based upon your experience with such systems, what is the probability of projection system failure over the course of a year of regular classes in such a room?
b. Develop a fault tree of potential causes for a classroom video projection system.
P4.6 (4 pts)
With the growth of internet service providers, a researcher decides to examine whether there is a correlation between cost of internet service per month (rounded to the nearest dollar) and degree of customer satisfaction (on a scale of 1 - 10 with a 1 being not at all satisfied and a 10 being extremely satisfied). The researcher only includes programs with comparable types of services. A sample of the data is provided below.
Dollars Satisfaction
11 6
19 8
17 10
15 4
9 9
5 6
12 3
19 5
22 2
25 10
a. Plot the data. Do you think dollars and satisfaction are related (or correlated)?
b. Estimate a linear regression with Satisfaction = a + b*dollars. Discuss your results.
P4.7 (3 pts)
Which of the following are transition matrices for Markov processes? Explain.
a. \begin{bmatrix}
.4 & .3 & .3 \
.2 & .4 & .4 \
.6 & .1 & .3 \
\end{bmatrix}
b. \begin{bmatrix}
.2 & .3 & .5 \
.6 & .1 & .2 \
.7 & .1 & .3 \
\end{bmatrix}
c. \begin{bmatrix}
.25 & .15 & .3 & .4\
.5 & 0 & .15 & .3 \
.15 & .35 & .4 & .2 \
.1 & .5 & .2 & .2 \
\end{bmatrix}
4.09: Chapter 9 References
References | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/04%3A_Deterioration_Modeling/4.08%3A_Chapter_4_Excercises.txt |
Infrastructure managers must make decisions on a regular basis. They must make decisions about allocating time and other organizational resources. For infrastructure components, managers must make decisions about maintenance and rehabilitation in each planning period. In many cases, the decision about procedures to apply to a particular infrastructure component may be to ‘do-nothing,’ but it is prudent for a manager to make such a decision consciously rather than simply from lack of oversight. With continuing deterioration, some maintenance or rehabilitation will be needed to prevent failure of the component.
This chapter discusses the use of optimization approaches to aid infrastructure management decision making. No previous experience with formal optimization approaches is assumed. Our intent is not to cover all the different approaches to optimization, but to illustrate how optimization might be used for infrastructure management. We don’t expect readers to become experts in optimization from reading this chapter. However, a manager may not ever develop their own optimization problem formulations. However, many asset management software programs include optimization sub-routines, and a manager using such programs should understand their approach. Also, optimization provides a useful conceptual approach to aid structuring decision making, even if formal optimization procedures are not used.
Optimization has been used in numerous applications that are not discussed in this chapter. In particular, optimization is used to aid production planning, vehicle routing, inventory controls, and engineering design. Optimization is also used for the estimation of parameter values. Regression models, as discussed in Chapter 4 on Deterioration Models, is a form of optimization. Just as one example, the package delivery company UPS uses optimization to suggest vehicle routes for their deliveries. The route planning minimizes driving costs in terms of time and fuel use. With route planning technology introduced in 2004, UPS has saved a million gallons of fuel each year (UPS 2016).
All optimization problems have some common features. The user is interested in searching for maximum (or minimum) values for an objective function. For infrastructure management, the objective might be to maximize the average condition of components or to minimize money spent on maintenance and rehabilitation. There are a set of decision variables obtained in finding an optimization solution. For infrastructure management, the most common decision variables are actions performed on particular components, such as rehabilitation options for different roadway sections. There are a set of constraints imposed on the decision variables. For example, there may be an available budget for infrastructure management, a minimum allowable component condition, or a requirement that one and only one rehabilitation option is chosen for each component in a single year. Finally, there is some solution process (usually called a solution algorithm) to obtain optimal values of the decision variables. In practice, management problems are sufficiently large that software packages are used to obtain such solutions.
Engineers and scientists first encounter optimization as part of the study of calculus. In particular, maximum values of a function with a single variable can be obtained by setting the first derivative to zero and insuring that the second derivative of the function is positive:
$\frac{d f(x)}{d x}=0, \frac{d^{2} f(x)}{d x^{2}}>0$
There may be a single value of x that maximizes the equation, or there may be multiple values. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.01%3A_Introduction.txt |
Problems with continuous decision variables and linear constraints and objective functions are very common and have attracted considerable research attention. These problems are solved with linear programming algorithms such as the Simplex method. Typical software can accommodate thousands of decision variables and constraints.
Formally, a linear program is represented as:
$\text{Maximize c} * \text{x subject to A x} =\text{y and x} \geq 0$
Where c is a vector of parameters, x is a vector of continuous decision variables, A is a matrix of parameters and y is a vector of constraint parameters. This formulation can accommodate inequality constraints with the addition of decision variables representing slack in the constraints. For example, the constraint $x1 + x2 ≤ 5$ (shown in Figure 5.2.1) would be re-written as $x1 + x2 + x3 = 5$ and a positive value of x3 in the optimal solution would indicate that the constraint is not binding. Similarly, decision variables can take on any value (both negative and positive) with the addition of decision variables. In practice, linear programming software can take as input inequalities and unconstrained decision variables and convert the problem into the standard form of Eq. 5.2.1.
A linear program has three types of solution possibilities:
• No solution is possible. An example would be: Maximize decision variable x subject to the constraints x < 1 and x > 5. No value of x will satisfy both constraints. For infrastructure management, an example would be if a budget is inadequate to achieve the required functional conditions.
• A single optimal solution exists. For example, a roadway management problem might be to maximize the average condition of roadway segments subject to a budget constraint. Typically, a set of maintenance actions (such as repaving or patching) for a subset of roadway segments will be identified that completely uses the budget. A more extensive example of this problem appears below.
Multiple optimal solutions exist. In Figure 5.2.1, the line segment between A and B includes an infinite number of optimal solutions which are combinations of the two decision variables x1 and x2 for the linear program Maximize $2 * x1 + x2 \text { subject to } 2 * x1+x 2 \leq 4 \text {and } x 1, x 2 \text { both} \geq 0$. The feasible region is the triangular area ABO.
Linear programs possess the useful property that the set of feasible solutions form a convex region. ‘Feasible’ in this context means a combination of decision variables that satisfy the problem constraints. The shaded area in Figure 5.2.1 is the feasible region for x1 and x2. The shaded area is convex because the line segment between any two feasible combinations of x1 and x2 would still be in the feasible region. This convexity has two useful implications. First, any optimal solution will not be a local optimum but would be a global optimum. That is, if you find a combination of x1 and x2 for which no improvement is possible from small changes, then no other combination of x1 and x2 with be better. Second, optimum values of the decision variables for a linear program problem will lie on the boundary of the feasible region, such as the line segment in Figure 5.2.1. This property is used by the Simplex solution algorithm for linear programs.
The Simplex method is a common solution method for linear programming problems. It begins with a ‘basic feasible solution.’ With m constraints and n decision variables, a basic feasible solution consists of n-m decision variables set to zero and the remaining m decision variables the solution to the m linear constraint equations. The simplex method checks to see if improvement is possible by exchanging one of the n-m decision variables set to zero with a decision variable in the basic feasible solution. If improvement is possible, the algorithm makes this switch, which is equivalent to ‘pivoting’ from one extreme point on the convex feasible region to another. Pivots continue until no such improvement is possible. An initial basic feasible solution can be obtained simply by adding ‘artificial decision variables’ equal to the value of constraint parameters and then pivoting away from these artificial variables.
Roadway maintenance and rehabilitation is a good example of linear programming applied to infrastructure management. In this application, a roadway network is divided into numerous short sections which might vary from a few kilometers down to individual blocks in an urban network (with index I ranging from 1 to n segments). Possible maintenance actions are defined for the roadway sections, such as filling potholes (j = 1), repaving (j = 2) or do-nothing (j = 3). Costs of each action for each pavement section are then estimated, usually based upon the area of the pavement section ($p_{ij}$). The condition of each pavement section is forecast assuming that one action is performed (filling potholes, repaving or doing nothing in this example) ($c_{ij}$ where lower values of $c_{ij}$ are more desirable). Then a budget constraint for actions and an objective function (such as maximizing average system condition) is defined. The result is a linear programming problem:
$\text {Minimize } \sum i \sum j \frac{x_{i j^{*}} c_{i j}}{n}$
$\text {subject to } \sum j x_{i j}=1 \text { for all } i$
$\sum i \sum j \quad x_{i j} * p_{i j} \leq B$
$x_{i j} \leq 0 \text { for all } i, j$
Where $x_{ij}$ is action $j$ on section I, $c_{ij}$ is forecast condition with action $j$ on section I, n is the number of roadway segments, $p_{ij}$ is the cost of action $j$ on segment I and B is the overall budget constraint.
In theory, the $x_{ij}$ might take on non-integer values between 0 and 1 in this formulation, but in practice, nearly all the optimal $x_{ij}$ would be zero or one.
A variety of modifications could be made to the basic formulation of Eq. 5.2.2 to 5.2.6. For the objective function (Eq. 5.2.2), the condition of each segment might be weighted by the amount of traffic and the segment area. These weights would lead the optimal solution to favor work on heavily traveled roadways and to minimize average roadway area conditions rather than average segment conditions as in Eq. 5.2.2. Additional roadway maintenance actions could be defined to extend the constraint Eq. 5.2.3. The problem could be altered by defining maximum allowable conditions as a constraint on each section and then minimizing the cost of achieving this constraint. Even without changing the objective function in this fashion, maximum allowable condition constraints can be added if desired.
This strategy of defining actions on infrastructure components is not restricted to roadway segments. For a manager of a military base or a campus, the problem formulation in Equations 5.2.2 - 5.2.5 might be used for roofs (with replacement or maintenance as actions), storm water components, building components or a range of other infrastructure systems.
In formulating linear programming problems, it is useful to address a series of questions:
• What are my possible decisions? How can they be represented as decision variables?
• What is my objective? Can it be represented as a linear function of my decision variables?
• What are the constraints on the chosen values of my decision variables? Can they be represented as linear functions of the decision variables?
Problem formulation is challenging but is an essential step in any optimization. Indeed, the formulation is more challenging than solution since there are many good software programs available for the solution.
The following example illustrates the use of the formulation questions.
Problem: Suppose you wish to minimize the cost of delivering ethanol from a set of production facilities with a maximum production supply Si where i goes from 1 to n, to a set of metropolitan petroleum mixing facilities (as ethanol is mixed with gasoline) with required amounts $P_j$ where j goes from 1 to m. Assume the cost of transportation from a production facility to a mixing facility is $C_{ij}$. Formulate a linear program problem to serve the required demand with the least cost.
• What are my possible decisions? How can they be represented as decision variables? The amount of ethanol shipped from each supply facility to each metropolitan area would be my decision variables. Let us define $x_{ij}$ as the amount of ethanol shipped from production facility.
• What is my objective? Can it be represented as a linear function of my decision variables? The problem statement gives the objective to minimize transportation costs. The objective function would be: $\sum i \sum j c_{i j} * x_{i j}$ which is total transportation cost and is linear with regard to decision variables.
• What are the constraints on the chosen values of my decision variables? Can they be represented as linear functions of the decision variables? One set of constraints is to ensure that ethanol shipped from each production facility does not exceed the available supply: $\sum i x_{i j} \leq S_{i}$ for each $i$. A second set of constraints is to ensure demand is met at each metropolitan area:$\sum i x_{i j} \geq P_{j}$ for each j metropolitan area. Finally, the flows must all be positive: $x_{i j} \geq 0$.
There are a variety of software packages that can be used for linear programming. For example, the spreadsheet program EXCEL has a routine for optimization called Solver. Frontline Systems (2016) has a tutorial available for the use of Solver. Readers interested in more in-depth treatment of linear programming might consult a relevant textbook (Boyd and Vandenberghe, 2004). | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.02%3A_Linear_Optimization_for_Infrastructure_Management.txt |
In many infrastructure management optimization problems, the decision variables may be restricted to integer values. For example, in the previous section, decision variables were defined as undertaking a particular maintenance or rehabilitation action j on a roadway segment i. While the decision variable could be a fraction, so that only part of the roadway segment undergoes a maintenance activity, it is more natural to manage the segment as a whole and wish to have binary decision variables that are zero or one.
Integer constraints impose several problems in obtaining optimal solutions. For linear programming, optimal values could be sought on the extreme corners of the feasible region. With integer value constraints, the optimal solution may be inside the feasible region. As illustrated in Figure 5.3.1, feasible integer values are shown as dots within a region satisfying the linear constraints. The only feasible solution on an extreme corner would be the solution $x1 = 0$ and $x2 = 0$. Point A marked on the figure would have fractional values of $x1$ and $x2$.
One approach to integer programming is to ignore the integer constraints and solve the problem as a linear program. With binary restrictions and integer parameters and constrain values, this approach works frequently to give optimal, binary solutions. A fractional decision variable value might be rounded by a manager to obtain a very good but not necessarily strictly optimal solution in this approach. Given the uncertainty in costs and action effects, the rounding might not affect the overall infrastructure performance.
More formal methods of obtaining optimal integer solutions also exist. A popular approach is ‘branch-and-bound.’ In this process, an initial linear solution is obtained, and then constraints are added to force the solution to be an integer. For example, in Figure 5.3.1, if point A was obtained as the optimal solution, and good additional constraint might be to require $x1$ to be 3 or less: $x1 \leq 3$. This would be a new ‘branch’ for the problem solution with a ‘bound’ that cuts out a portion of the region that does not contain integer values. Adding constraints in this fashion would continue until an integer-valued optimal solution is obtained.
‘Branch and bound’ or other integer programming approaches are part of most popular optimization software, including the Solver program for the EXCEL spreadsheet. Integer constraints are specified when problems are input to the programs. However, solving integer programs requires more calculation time than comparably sized linear programs. While linear programs with thousands of decision variables can be easily solved, integer programs may be realistically limited to hundreds of decision variables. Still, this could well a useful range for many infrastructure management problems.
The ‘traveling salesman’ problem is a classic example of an integer programming problem. The problem is to develop a round-trip tour that visits each and every one of a set of cities exactly once with minimum travel distance. For infrastructure management, a tour of this type might be formulated by an inspector of different infrastructure components or a maintenance worker with a set of assigned jobs. In these problems, ‘cities’ would be inspection or job sites. The UPS routing software for delivery trucks mentioned in the introduction to this chapter solves this problem (UPS 2016). Variations of the problem can be found in manufacturing (where ‘cities’ may be spots on a chip) and DNA sequencing.
A decision variable for the traveling salesman problem might be $x_{ij}$ which is 0 if the trip from $i$ to $j$ is not on the tour and 1 if the trip from $i$ to $j$ is on the tour. The objective function would be to sum the distance (or cost) of the trip from $i$ to $j$ multiplied by the $x_{ij}$ values. Only those trips which are part of the tour would incur any distance and affect the value of the objective function. Constraints require that there is exactly one departure from each city (so the sum of the $x_{ij}$ from I equals one) and exactly one arrival at each city. Additional constraints are needed to ensure that the tour is complete (that is, the tour doesn’t have multiple disjoint circuits). Finally, the decision variables $x_{ij}$ are restricted to zero or one.
Numerous specialized algorithms have been developed for the traveling salesman problem. In practice, heuristic approaches can obtain very good (but not necessarily optimal) solutions. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.03%3A_Integer_Optimization_for_Infrastructure_Management.txt |
As discussed earlier, most infrastructure management optimization problems are formulated as linear programming problems. However, in some cases, non-linear optimization may be needed. The general form of the non-linear optimization problem is:
$\text{Minimize or Maximize } f(x) \text{ subject to } g_{i}(x) \leq 0 \text{ and } h_{j}(x)=0$
Where $x$ is a vector of decision variables, $f(x)$ is a non-linear objective function, $g_i(x)$ and $h_j(x)$ are sets of constraints which may be linear or non-linear.
One source of non-linearities is that of scale economies in performing a maintenance or rehabilitation task. This might occur if there are fixed mobilization costs to undertake a task which are then spread over the amount of work. Components such as tanks also have scale economies since their volume grows faster than the (expensive) tank surface as the tank size increases. Figure 5.4.1 illustrates scale economies in two related graphs. In the upper graph, the cost per unit of work declining as the amount of work increases. In the lower graph, the total cost goes up slower than the increase in the amount of work.
Another source of non-linearity for infrastructure management comes from flow effects. For example, roadway traffic congestion is non-linear in that a small increase in traffic may result in large amounts of delay. With roadway maintenance blocking lanes of traffic, the capacity of the roadway network is reduced and congestion may increase considerably. Figure 5.4.2 illustrates the non-linear increase in average travel time.
Non-linear optimization has some pitfalls. First, solutions obtained may not be global optimum but only local maximum or minimum values of the objective function. Second, particular formulations may lead to physically impossible results. For example, in a case of scale economies, a non-linear optimization may wish to build the top few feet of a dam rather than the entire dam since the top two feet would hold more water back than average and would be cheaper to build!
Most non-linear optimization uses some form of a gradient approach in which a set of feasible decision variable values are chosen and then these are altered to improve the objective function and still remain feasible. Solver in the spreadsheet program EXCEL uses this type of technique. In many cases, it is useful to use multiple starting points to reduce the chance of ending up with a local optimum.
As an example of non-linear optimization useful for infrastructure management, we can suggest a flow problem which can be applied to traffic flow in road networks or water flow in pipe networks. The costs of maintenance or rehabilitation work can be estimated by comparing flow costs before and during network disruption. The same approach can be used for assessing new capacity or operating procedures. The problem appears in Hendrickson (1984).
We assume that a network exists with a set of nodes (intersections) N and arcs (pipe links or streets) A. There is a cost of flow on link $ij$ $f(y)$ which is assumed to be monotonically increasing as in Figure 5.4.2. This assumption is physically realistic and insures convexity for the problem-solution space making a solution easier.
The general problem of equilibrium flow is:
$P1: \text { minimize } \sum_{(i, j) \in A} \int_{0}^{x_{i j}} f_{i j}(y) d y$
subject to:
$\sum_{(i, k) \in A} x_{i k}-\sum_{(k, j) \in A} x_{k j}=q_{k} \text { for all } k \in N$
$x_{i, j}>0 \text { for all }(i, j) \in A$
Where $x_{ij}$ is flow on link $ij$ and $qk$ is the net inflow or outflow at node k. The objective is to minimize ‘impedance’ of flow on each link, and the constraints conserve flow through nodes and require all flows to be positive.
For pipeline hydraulics applications, the flow would be fluid flow measured in volume per unit time. The impedance function would be head loss (or gain) per unit of distance. The impedance function should include elevation differences of nodes as well as pipe friction loss (through a function such as the Hazen-Williams function $f(x) = k*x^m$.
For traffic networks, a slightly more complicated form of the problem must be used to keep track of flows between particular origins and destinations. The impedance is travel time and relates to total flow on link $ij$. Problem P2 below shows the traffic flow problem with the rs notation for traffic from node r to node s, a constraint to insure conservation of flow through intersection nodes, and a constraint to aggregate the individual origin-destination flows for each link.
$\text {P2: minimize } \sum_{(i, j) \in A} \int_{0}^{x_{i j}} f_{i j}(y) d y$
$\sum_{s \in A}\left[\sum_{(i, k) \in A} x_{i k}^{r s}-\sum_{(k, j) \in A} x_{k j}^{r s}\right]=q_{r k} \text { for all } k \in N, r \in N$
$\sum_{s \in N}^{r \in N} x_{i j}^{r s}=x_{i j} \text { for all }(i, j) \in A$
For the traffic flow application, the solution set of flows represents a ‘user equilibrium solution’ in which the travel time on each path used between origin r and destination s has the same overall travel time (if not, travelers would change the path and reduce their travel time). Paths not used between origin r and destination s would have higher travel time and would be unattractive.
As noted earlier, the problem P2 could be solved to obtain travel times and flows on an existing network. After the network is altered due to construction, the equilibrium travel time after the alteration could then be modelled. Noted that in this simple application form, the origin-destination flow would not change. More elaborate analysis could relax this assumption to allow new destinations or other travel choices.
Gradient solution algorithms exist for problem P1 and P2 that can easily accommodate thousands of nodes and links. Author, (Hendrickson, 1984) presents one solution algorithm as well as additional applications of the model form to project task scheduling and structural analysis. Numerous software programs exist for this type of model formulation. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.04%3A_Non-Linear_Optimization.txt |
The previous section illustrated the use of expected component conditions for use in optimization and decision making. It is also possible to include a distribution of possible conditions over a period of time. The most common means of making this synthesis is to combine optimization with Markov deterioration models. A number of bridge and pavement management systems are based on this synthesis; for example, see AASHTO (2016) or Golabi (1997). It is unlikely that an infrastructure manager would formulate an optimization problem synthesis such as these, but managers regularly use the software programs embedding the synthesized optimization.
Table 5.5.1 presents an example of a Markov process transition matrix and possible actions for a concrete component. Five condition states are defined, with 1 representing good condition and 5 representing failure of the component. For components in state 1, recommended management action is to do nothing. In each year in State 1, there is a 3% chance of deterioration to state 2. For components in states 2 and 3, do-nothing or patch are possible actions with the probability consequences as shown. There are substantial chances that the patching may not be effective, as the components might remain in their initial state or deteriorate further (although with a low probability of such deterioration). For components in state 4, do-nothing, rehabilitation or replacement are possible actions. With do-nothing action and initial state 4, there is a 13% chance of failure over the course of a year.
Table 5.5.1: Illustrating a Markov Transition Probability Matrix with Different Management Actions.
Initial State Action $Pr\text{(state 1)}$ $Pr\text{(state 2)}$ $Pr\text{(state 3)}$ $Pr\text{(state 4)}$ $Pr\text{(state 5)}$
1 Do Nothing 0.97 0.03 0.0 0.0 0.0
2 Do Nothing 0.0 0.97 0.03 0.0 0.0
2 Patch 0.62 0.34 0.04 0.0 0.0
3 Do Nothing 0.0 0.0 0.92 0.08 0.0
3 Patch 0.52 0.35 0.10 0.03 0.0
4 Do Nothing 0.0 0.0 0.0 0.87 0.13
4 Rehabilitate 0.68 0.27 0.05 0.0 0.0
4 Replaca 0.99 0.01 0.0 0.0 0.0
An initial analysis step with a table of transition probabilities such as this could be to minimize the long-term cost of maintaining the concrete component. Of course, doing nothing at each stage would minimize cost, except that eventually the component would fail. Presumably, a manager would attempt to minimize cost subject to avoiding transitioning to state 5. Decision variables would be a particular action given a state. The objective function would be to minimize expected condition (or perhaps the probability of failure). With a planning horizon and an initial state, the changes in probabilities over time can be traced as a linear function of the decision variables. A budge constraint might also be imposed (as in Eq. 5.2.4) added over all the bridge components being managed.
We will illustrate this optimization approach with a small problem. Suppose a set of identical components can have three possible condition states: 1 – good, 2 – average and 3 – poor. One maintenance activity can be undertaken, which will move the component from any state to state 1 at a cost of ci. Table 5.5.2 shows the transition probabilities for the component with do-nothing and maintenance. Finally, there is a budget available for the year and a known state si for each component.
Table 5.5.2 - Illustrative Transition Probabilities and Actions for a Small Problem
Initial State Action $Pr\text{(state 1)}$ $Pr\text{(state 2)}$ $Pr\text{(state 3)}$
1 Do Nothing 0.8 0.2 0.0
1 Maintenance 1.0 0.0 0.0
2 Do Nothing 0.0 0.8 0.2
2 Maintenance 1.0 0.0 0.0
3 Do Nothing 0.0 0.0 1.0
3 Maintenance 1.0 0.0 0.0
Following the formulation approach discussed in the previous section:
• Let us define our decision variable as $x_i = 0$ if do-nothing and $x_i = 1$ if maintenance is performed. (If there were more than two actions possible, then we could add a subscript as in Eq. 5.2.2 for each component and each possible action, and the decision variable $x|{ij}$ would be 0 if the action $j$ was not undertaken on component $I$ and one if action $j$ was taken on component $i$).
• Let us assume that the objective is to minimize the average component condition.
• The only constraint is the budget constraint for all the actions. (If more than one action is possible, however, we would have to add a constraint similar to Eq. 5.2.3 for each component, however).
The resulting problem is:
$\text{Minimize Average Condition State}$
$=\sum_{s=1}(.8+2 * .2) *\left(1-x_{i}\right)+\sum_{s=2}(2 * 0.8+3 * 0.2) *\left(1-x_{i}\right)+\sum_{s=3} 3 *\left(1-x_{i s}\right)+\sum_{i} x_{i}$
$\text {Subject to } \sum_{i} c_{i} * x_{i} \leq B, x_{i} \text { binary }$
Where the objective function has four terms: (1) resulting condition of components in state 1 with no action, (2) resulting condition of components starting in state 2 with no action, (3) resulting condition of components in state 3 with no action (they stay in state 3), and (4) components with maintenance moving to state 1. The constraints are the overall budget and the restriction of the $x_i$ to zero or one. As noted above, variation would add additional potential actions (using notation \(x_{iS}) and different resulting conditions. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.05%3A_Combining_Linear_Optimization_with_Markov_Deterioration_Models.txt |
P5.1 (8 pts)
Suppose I am managing a system of n cell phone sites. A site consists of ‘antennas and electronic communications equipment placed on a radio mast or tower to create a cell in a cellular network.’ I have records of the age of the electronic equipment (\(a_i\) where \(a\) is the current age of the site \(i\)) and a physical condition assessment rating (\(r_i\) where \(r\) is the condition rating index for a site \(i\) on a scale of 1 to 5 with 1 being excellent) of the physical systems each year. I also have a measure of the importance of each site, \(t_i\) where \(t\) is the amount of cellular traffic at a particular site \(i\). In each year, routine maintenance is performed at each site. I can also choose to rehabilitate the physical site (antenna towers, etc.) (which would move the site to condition 2, replace the electronic components (which would also move the site to condition 2), or do both physical rehabilitation and electronic component replacement (which would move the site to condition 1). Each of these actions has an associated cost, denoted \(c_{ij}\) where \(i\) indicates a particular site \(i\) and \(j\) is one of the management strategies.
Formulate a linear programming decision model that would select the best management action for each site in the coming year. ‘Formulate’ means to write out the problem equations. Define appropriate decision and other variables. Your objective is to minimize the sum over all sites of site condition multiplied by importance of each site. Your constraints are an allowable budget and a requirement that the electronics must be replaced if the age is greater than 6 years old.
P5.2 (4 pts)
Suppose you wish to minimize the cost of delivering ethanol from a set of production facilities with a maximum production supply \(S_i\) where \(i\) goes from 1 to \(n\), to a set of metropolitan petroleum mixing facilities (as ethanol is mixed with gasoline) with required amounts \(P_j\) where \(j\) goes from 1 to \(m\). Assume the cost of transportation from a production facility to a mixing facility is \(C_{ij}\).
a. Formulate a linear program problem to serve the required demand with the least cost.
b. What might cause your linear program to be infeasible for the solution?
P5.3 (8 pts)
Let us try an application of a roadway management system optimization model. Suppose I have a small roadway network with 10 links as shown below. In this example, we will just number links (rather than naming them by beginning and endpoints) and consider three action possibilities with forecast pavement conditions post-action as shown. Pavement condition varies from 1 to 7, with 7 excellent. This problem is sufficiently small that in can be solved with the add-in solver program in EXCEL.
Link Length Average Daily Traffic PCI Do-Nothing PCI with Main Maintenance Cost Rehabilitation Cost PCI with Rehab.
1 5 10 4 5 5 16 7
2 4 13 3 4 4 15 7
3 3 12 3 4 3 10 7
4 6 11 2 3 6 20 7
5 7 25 5 6 7 22 7
6 5 50 4 5 5 20 7
7 4 40 3 4 4 15 7
8 3 20 3 4 3 10 7
97 8 15 2 3 8 28 7
10 2 10 1 2 2 6 7
a. Your objective function will have 30 terms, corresponding to the 10 links multiplied by three possible action decision variables: do-nothing, maintenance or rehabilitation. Each term is the product of length, average daily traffic, forecast pavement condition index (PCI) and a decision variable and divided by the sum of the product of length times average daily traffic. Write out your complete problem formulation, including definitions of variables, the various terms in your objective function, and your various constraints (including non-negativity and integral restrictions).
b. Find optimal solutions for budgets of 40 and 100. What do you conclude about the maintenance and rehabilitation strategies from your results?
c. Do either of your optimal solutions have a fractional decision variable value? What could you do about this in practice knowing that costs and pavement conditions are all uncertain?
d. Do you think this problem formulation and data are reasonable? Why or why not?
P5.4 (4 pts)
Let us couple a linear programming problem with a Markov deterioration model. Suppose you have components with three possible States: 1 – good, 2 – ok, 3 – poor. You have one possible action: moves to state 1 with probability 1 at cost ci for component i. State transition probabilities with no action are: p11 = .8, p12=.2, p22 = .8, p23 = .2, p33 = 1. others zero. You have a budget B for the year and current conditions are described by a vector \(si\). Formulate problem to minimize the average condition of all components at end of the year.
P5.5 (8 pts)
The facility manager of a plant is attempting to devise a shift pattern for his workforce. Each day of every working week is divided into three eight-hour shift periods (00:01-08:00, 08:01-16:00, 16:01-24:00) denoted by night, day and late respectively. The plant must be manned at all times and the minimum number of workers required for each of these shifts over any working week is as below:
• Mon Tues Wed Thur Fri Sat Sun
• Night 5 3 2 4 3 2 2
• Day 7 8 9 5 7 2 5
• Late 9 10 10 7 11 2 2
• The union agreement governing acceptable shifts for workers is as follows:
• Each worker is assigned to work either a night shift or a day shift or a late shift and once a worker has been assigned to a shift they must remain on the same shift every day that they work.
• Each worker works four consecutive days during any seven day period.
• In total there are currently 60 workers.
• Formulate an optimization problem to minimize the number of workers in the labor pool.
5.07: Chapter 5 References
References
• AASHTO (2016), ‘AASHTOware Bridge Management,’ http://aashtowarebridge.com/ (accessed August 4, 2016).
• Boyd, Stephen, and Lieven Vandenberghe. Convex optimization. Cambridge university press, 2004. http://web.stanford.edu/~boyd/cvxbook/ (accessed August 3, 2016).
• Frontline Systems (2016), ‘Optimization Tutorial’, http://www.solver.com/optimization-tutorial
• Golabi, Kamal, and Richard Shepard. "Pontis: A system for maintenance optimization and improvement of US bridge networks." Interfaces 27.1 (1997): 71-88.
• Hendrickson, Chris T., and Bruce N. Janson. "A common network flow formulation for several civil engineering problems." Civil Engineering Systems 1.4 (1984): 195-203.
• UPS, (2016) UPS Accelerates Use of Routing Optimization Software to Reduce 100 Million Miles Driven, https://www.pressroom.ups.com/pressr...6329559785-791 (accessed August 3, 2016). | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/05%3A_Optimization_and_Decision_Making/5.06%3A_Chapter_5_Exercises.txt |
Some infrastructure managers adopt a narrow view of their work, focusing simply on maintenance and rehabilitation decision making. However, an appreciation and understanding of the overall performance, costs, and finance of infrastructure is extremely useful in interacting with the users of infrastructure and organizational decision-makers. For example, an extremely congested roadway may be in good physical condition, but users of the roadway are likely not to appreciate the good pavement condition while waiting in traffic queues. Figure 6.1 illustrates a roadway in good condition but with heavy traffic congestion. This chapter is intended to provide an understanding of the fundamentals of infrastructure costs and finance topics.
The amounts and components of infrastructure costs depend upon your viewpoint. For a building manager’s viewpoint, costs might be limited to the initial construction (or the payments for borrowed money used for construction), building utilities and maintenance. However, the building occupants might incur costs if the roof leaks, power fails or water is unavailable. If the building has a boiler, then air emissions might impose costs on nearby residents. The air emissions costs are often called ‘external’ since they don’t appear on any accounting sheet for the building. However, any public health effects due to such air emissions represent real social costs. Whenever considering costs, the appropriate viewpoint should be selected, whether social or private!
6.02: Short Run Cost Functions for Infrastructure
Economists differentiate between short-run and long-run cost functions. In the short run, capital facilities are fixed. That is, an infrastructure manager must deal with the existing facilities. Any major capital project will take a year or more to be implemented to change facilities. In the long run, capital projects may be implemented, so additional capacity and facilities may be added.
Short and long-run are useful distinctions for developing cost functions, but there are many cases in which intermediate run cost functions may be needed when operational changes might be accomplished. For example, a transit manager may be limited to no changes in operations in the short run. However, schedule and route changes may be made without major capital expenditure. Vehicle fleets can be altered with new purchases in a somewhat longer time frame. Over the long run, capital facilities such as garages, rail lines and busways might be changed.
Costs can be divided into fixed costs of providing a facility and variable costs which depend upon usage. Fixed costs would be the cost of infrastructure services even without usage. Examples include:
• Roadways for transportation
• Generating plants, transmission lines and distribution lines for power
• Pumps, pipes, and storage for water systems
• Buildings for office infrastructure.
In many infrastructure cases, these fixed costs may be substantial.
Variable costs are incurred to provide infrastructure use. These costs generally increase as the amount of usage increases. For example, more maintenance is needed as the travel volume on a roadway increases. As another example, more building occupants will result in more power use, bathroom use and elevator trips. In most infrastructure systems, there are capacity constraints in which the variable cost increase rapidly as capacity is approached. An example is the roadway congestion shown in Figure 6.1 in which the user cost of travel is quite high. Buildings often have a maximum allowable occupancy, but crowding may be uncomfortable even before this maximum is attained.
Figure 6.2 illustrates the important short fun cost functions of interest for infrastructure management. The top graph in Figure 6.2.1 shows a fixed cost (F) even with no usage. As usage increases, the short-run total cost (SRTC(q)) increases, where q is a measure of usage such as traffic volume. If no capacity constraints or congestion effects exist, then the SRTC might increase as a straight line.
The bottom graph in Figure 6.2 shows three different short run cost curves:
• Short Run Average Total Cost is the total cost divided by usage:
$\operatorname{SRATC}(q)=\frac{\operatorname{SRTC}(q)}{q}$. This curve initially declines as fixed costs are spread over more usage. Eventually, capacity constraints and congestion result in higher costs and the SRATC begins to increase. A line drawn from the origin to the SRTC curve has a slope equal to the short run average total cost. The low point of the SRATC curve occurs where such a line has minimum slope and is tangent to the SRTC curve.
• Short Run Average Variable Cost is the total cost less fixed cost divided by usage:
$S R A V C(q)=\frac{[S R T C(q)-F]}{q}$
• This curve increases as capacity constraints and congestion result in higher costs. In the absence of such effects, the SRAVC(q) would be a flat, horizontal line.
Short Run Marginal Cost is the derivative of the SRTC with respect to q (or approximately the change in total cost from an additional unit of usage: $\operatorname{SRMC}(q)=\frac{\delta \operatorname{SRTC}(q)}{\delta q} \approx \frac{[\operatorname{SRTC}(q)-\operatorname{SRTC}(q-1)]}{q}$. The SRMC begins at a low value and increases as capacity constraints and congestion effects. The SRMC crosses the SRATC curve at its lowest, inflection point. Beyond this point, the marginal cost of additional usage exceeds the average cost.
As noted in the introduction, these various cost curves will differ depending upon the analysis viewpoint adopted. The major changes occur if external and user costs are included or not included. For a roadway system, user costs would include vehicle operating costs, travel time opportunity cost and potential costs from crashes. Vehicle operating costs include taxes that support roadway maintenance and construction in many cases. Travel time opportunity cost will likely vary with the income (or wealth) of the traveler and the opportunities foregone. A passenger in an autonomous, self-driving vehicle might have low travel time opportunity cost since the passenger could be doing activities other than driving. External costs would include air emissions effects, congestion and crash costs. Many of these ‘external’ costs are external to any individual traveler but are borne by other travelers. For example, an additional vehicle may add congestion that is a travel time penalty for the other vehicles on the road.
For telecommunications infrastructure, these cost functions would differ by type of technology used. For broadcast, over-the-air radio and television stations, all costs are fixed and no congestion effects occur so the SRTC function would be a horizontal line.
As many users can listen or watch as are in the area being served. This is an unusual situation and represents a ‘public’ good in the parlance of economics in which users cannot be easily excluded and do not interfere with other users. In contrast, cellular service infrastructure has capacity limits in base units, so greater usage imposes user costs in the form of inferior service. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/06%3A_Performance_Usage_Budget_and_Cost_Functions/6.01%3A_Introduction.txt |
As noted earlier, low usage is usually associated with declining average costs as fixed costs are spread over more users. For medium usage, the average costs are fairly flat and don’t change dramatically. With high usage, capacity constraints and congestion come into play and the average costs begin to increase.
Usage of infrastructure systems tends to vary considerably over time and over geography. As a result, costs also tend to vary considerably. As an example, Figure 6.3.1 illustrates a typical variation in traffic volumes by time of day, with the peak travel occurring the morning and the late afternoon. Roadway congestion is heaviest in these peak hours of travel. As another example, Figure 6.3.2 illustrates typical electricity demand by time of day for two different months. In this case, there is variation in demand over the course of a day, but it is not as extreme a fluctuation as for roadway traffic. Figure 6.3.2 also shows that electricity demand varies over the course of a year, with higher demand in the summer likely due to air conditioning use.
Infrastructure managers often must respond to these fluctuating demands. In many cases, maintenance activities are scheduled for low usage periods to avoid imposing costs. For example, building floors may be cleaned at night. As another example, power grid managers must respond to not only varying demand (as shown in Figure 6.3.2), but also varying supply as solar and wind generators respond to environmental conditions.
Another important variation in demand for many infrastructure systems occurs over time, from year to year or over the course of decades. For example, demand for water will typically increase with an increase in population. Demand for electricity will also typically increase with population, but may also depend upon the numbers of households being served, incomes and new technologies. New technologies may reduce demand (with more energy-efficient refrigerators for example) or increase demand (with battery electric vehicles or fancier entertainment systems).
To the extent that cost functions represent user costs, then the cost functions shown in Figure 6.2.1 can be coupled with demand functions to estimate equilibrium demand for service. Figure 6.3.3 illustrates a linear user cost and demand curve for a service. The 90
equilibrium demand occurs at the intersection of the two curves with usage \(q_e\) and user cost \(p_e\). Of course, demand is likely to be varying over time, so the equilibrium demand and user costs will similarly vary.
6.04: Budgets and Revenues from Usage
In addition to the cost implications of different levels of infrastructure usage, there is often a revenue effect. Many infrastructure systems obtain revenues from user fees such as power sales or gasoline taxes. In turn, budgets for infrastructure maintenance and rehabilitation rely upon these revenues. The alternative to using user fees is to rely on general taxation of some sort, but this is only feasible for public infrastructure.
Generally, user fees can be set at any level. A few cases of user fee strategies are of interest:
• Set user fees equal to the short run average total cost of providing the infrastructure. In this case, the infrastructure provider is fully funded and compensated for the infrastructure service costs.
• Set user fees equal to an amount that maximizes total revenue. This strategy can be pursued with an optimization problem to maximize revenue (\(p*q\) where \(p\) is user fee and q is equilibrium usage) subject to the demand function (\(q = f(p,x)\) where \(f(p,x)\) is a demand function with usage dependent upon the user fee and other factors \(x\)). Even with a maximizing revenue strategy, usage may not be sufficiently high to cover all agency costs. For example, the Pennsylvania turnpike has increased tolls every year from 2008 to 2016 and made transfer payments to the Commonwealth of Pennsylvania, but the managers feel that the revenues are insufficient in the long run to maintain the system effectively and make required transfer payments (Pittsburgh Post-Gazette, 2016).
• Set user fees in accordance with user’s willingness-to-pay. Demand curves reflect an individual’s willingness-to-pay for infrastructure services. If the user cost function shifted up in Figure 6.3.3, some usage would disappear but a remaining amount of usage demand would continue at higher user cost. With a single user cost, the revenue would be roughly \(q_e * p_e\) in figure 6.3.3 (less any user costs incurred directly rather than as a service price). Perfect price discrimination would gain revenue equal to the complete area under the demand curve in Figure 6.3.3 (again less any user costs incurred directly). However, individuals don’t usually reveal their willingness-to-pay for service and there are restrictions on discriminating among different types of users. Indirect methods can be adopted, however, such as lower airline fares for earlier purchases or for trips involving a Saturday night stay. Business travelers with a higher willingness-to-pay tend to make late purchases and not stay at destinations over a weekend.
• Set user fees equal to short run marginal cost. This is a common economics prescription because this strategy will minimize overall costs as long as the short run marginal cost function includes all relevant social costs (including externalities). Users would be paying exactly the cost associated with their service use. Unfortunately, it is difficult to impose short run marginal cost pricing exactly since demand fluctuates so much. An example of approximating this policy appears in Figure 6.4.1, where toll on a roadway in San Diego CA increase during peak periods of travel demand. By increasing tolls, some users would be diverted from the roadway and congestion costs avoided. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/06%3A_Performance_Usage_Budget_and_Cost_Functions/6.03%3A_Demand_Fluctuation_with_Low_Medium_and_High_Usage_Situations.txt |
For long term rehabilitation investment planning, a life cycle viewpoint is normally used. ‘Life cycle’ in this context generally refers to a planning horizon for investments and not necessarily the obsolescence of some infrastructure. In performing life cycle analysis, you must select an appropriate planning horizon, a discount rate to account for the time value of money, and forecast benefits and costs of the infrastructure over the course of the planning horizon.
Selection of a planning horizon and a discount rate are often organizational choices, so most infrastructure managers need not be concerned with these two inputs. For the US, any project involving federal dollars must use the discount rate chosen by the US Office of Management and Budget (OMB, 2015). In the absence of organizational guidance, an infrastructure manager might use a discount rate reflecting marketplace long term borrowing rates and a planning horizon consistent with the expected useful lifetime of the infrastructure. For example, a planning horizon for a building might be fifty years, while a cellular hub might be ten years.
Even formulation of the short run cost functions discussed earlier can involve life cycle cost analysis to estimate the fixed costs of infrastructure in each period. Infrastructure typically requires an initial large capital expenditure for construction, and this fixed cost is usually annualized to uniform amounts to obtain the fixed costs allocated to any year of operation. The formula for annualization of an initial cost $P$ to uniform amounts $U$ over a planning period with n compounding periods at a discount rate $I$ is (Au, 1992):
$U=P\left[\frac{i(1+i)^{n}}{(1+i)^{n}-1}\right]$
Where $U$ is the uniform annualized amount, $P$ is the present expenditure, $i$ is a discount rate and $n$ is the planning horizon (or technically the number of compounding periods). This process is equivalent to that of assuming a mortgage on the infrastructure component in which the entire construction cost is borrowed at an interest rate of $i$ and a repayment period of $n$ years.
Why isn’t the uniform amount simply the value $P$ divided by the number of payment periods, $frac{P}{n}$? The use of a discount rate reflects the ‘time value of money.’ Lenders usually require a return on their lending, so they charge an interest rate. Individuals always prefer receiving money in the present rather than an equivalent amount in the future. The amount of extra required to make a future amount equivalent is a personal discount rate. Organizational discount rates are typically set with reference to the market equilibrium for long term borrowing.
In addition to the initial capital construction expenditure, infrastructure will often have major expenditures associated with rehabilitation. Figure 6.5.1 illustrates this type of rehabilitation. The pavement condition deteriorates during use and weathering until a rehabilitation occurs. The rehabilitations have lower cost than the initial construction and take place over the service lifetime of the pavement. For discussion of methods of estimating such costs, see Hendrickson (2008).
How can these rehabilitation expenses be converted into a uniform annual cost? The most direct means is to find the present value of such costs over the infrastructure lifetime by discounting future costs:
$P=\sum_{(t=o)}^{n} F_{t}(1+i)^{-t}$
Where P is present value, t is a time index, n is the planning horizon, Ft is the cost incurred in year t, and i is the discount rate. Uniform costs can then be obtained using Equation 6.5.1.
As a numerical example, suppose the costs illustrated in Figure 6.5.1 are estimated as shown in Table 6.5.1. With a 30-year planning horizon and a 1% discount rate, the life cycle costs (in $million) would be: $\text{P = Initial Construction Cost + Discounted First and Second Rehabilitation + Discounted Maintenance Cost}$ $=5+\frac{2}{1.01^{10}}+\frac{1}{1.01^{20}}+\sum_{t=1}^{30} 0.1 * 1.01^{-t}$ $= 5 + 1.8 + 0.8 + 2.6 = 10.2$ For a social cost analysis of the pavement, user costs of roadway delays for construction might be added. Table 6.5.1: Illustration of Costs for a Life Cycle Cost Analysis. Cost COmponent Year of Occurence Cost Estimate (Base year$)
InitialConstruction 0 $5 million First Rehabilitation 10$ 2 million
Second Rehabilitation 20 $1 million Annual Maintenance Each year 1-30$ 0.1 million
Inflation and deflation will affect life cycle cost analysis if current dollars are used for analysis. With inflation, the purchasing value of a unit of currency declines over time; deflation reflects an increase in the value of a currency. Current dollar amounts can be converted to ‘real’ or base year dollar amounts by applying an inflation index adjustment: $\text(Index_{base year} / Index_t)$ or by discounting using Eq. 6.5.2 and the expected rate of inflation. Different types of infrastructure have their own inflation indexes or a general index such as the gross domestic product index can be used. Life cycle cost estimates are generally made in base year ‘real’ dollars. Financial agreements for payments such as mortgages usually are based upon current dollars. With these mixed dollar amounts, you should apply an inflation calculator to convert to one type of dollar amount.
Discount rates also can be for constant ‘real’ dollars or for current inflated dollars. The relationship is:
$I' = I + j = ij$
Where $I’$ is the annual discount rate including inflation (for current dollar discounting), $I$ is the real discount rate, and $j$ is the inflation rate. Readers unfamiliar with these engineering economics calculations can refer to Au (1992) or other textbooks.
For investment decisions, the life cycle costs can be compared to the life cycle benefits in a similar fashion by placing the costs and benefits into present values. In this case, you can examine the net present value of an investment: $\text(NPV = P_{benefit} – P_{cost})$. With a series of mutually exclusive infrastructure design or rehabilitation options, you might select the one that maximizes this net present value.
Spreadsheet or numerical analysis software is readily available to perform the engineering economics calculations for analyzing life cycle costs. For a spreadsheet, a separate row (or if you prefer a separate column) is used for each period and the costs and benefits recorded. The discounting functions in Equations 6.5.1 and 6.5.2 are usually already available in the software. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/06%3A_Performance_Usage_Budget_and_Cost_Functions/6.05%3A_Life_Cycle_Costs_Taxes_and_Finance_of_Infrastructure.txt |
It is possible to also develop long run cost functions in which the infrastructure itself may be changed to maximize net present value. In particular, rather than incur the high costs of congestion in high usage situations (as in Figure 6.3.1), an infrastructure manager might add capacity as rehabilitation investments are made.
The long run total cost curve is the lower cost envelope of all possible short run total cost options. Figure 6.6.1 illustrates the situation in which two possible infrastructure capacity options exist (which might represent different size components, an additional floor on a parking garage or an additional lane of roadway capacity). There is a usage point (\(q_b\)) in Figure 6.6.1 at which it is desirable to shift from option 1 to the larger capacity option 2. The long run average total cost has a significant turn at this usage breakpoint, with scale economies beginning again! The long run marginal cost curve has a discontinuity at the breakpoint. With lower demand (demand curve \(D\)), the smaller option has lower costs, but with higher demand (demand curve \(D’\)), the larger option 2 is more desirable.
6.07: Decision Analysis and Monte Carlo Simulation for Investment Decisions
The earlier discussion in this chapter noted the effects of demand fluctuations but did not address uncertainty and contingencies. However, costs and demands are likely to be quite uncertain to forecast. Moreover, external events such as extreme events may also profoundly affect infrastructure costs, demand, and usage.
A common approach to dealing with uncertainty is to employ some form of ‘Monte Carlo’ simulation, where the name ‘Monte Carlo’ refers to a casino in Monaco with gambling on chance events. Monte Carlo simulation requires not only cash flow estimates in 98
each year, but also the probabilistic distributions of such cash flow as input information. As a result, there is considerably more work to prepare input (which is expensive and still uncertain) and to perform calculations (which fortunately is not very expensive with modern information technology).
The essential idea of Monte Carlo simulation is to obtain a sample from input parameter distributions and then assess the outcome from this sample. This process of sampling and assessment is repeated numerous times, resulting in a distribution of possible outcomes. So rather than a fixed, deterministic estimate of life cycle costs, Monte Carlo simulation results in a probability distribution of possible life cycle costs.
As an example, suppose you decided to do a Monte Carlo simulation of the life cycle roadway cost shown in Table 6.5.1 and Equation 6.5.2. The parameters in Table 6.5.1 might be used as input for a Monte Carlo roadway life cycle cost analysis with the following assumptions:
Table 6.7.1: Illustrative Input Parameter Distributions for a Roadway Life Cycle Cost.
Component Year of Occurrence Cost
Initial Construction 0 N(5,1)
First Rehabilitation U[8,12] N(2,2)
Second Rehabilitation U[16,24] N(1,1)
Maintenance Each Year 1-30 U[0.05,0.15]
Monte Carlo Simulation (Note: $N(\mu, \sigma)$ is normal distribution with mean $\mu$ and standard deviation $\sigma$, and $U[i,u]$ is the uniform distribution with lower bound $i$ and upper bound $u$).
The assumed parameter distributions are either normal or uniform with the mean equal to the values in Table 6.7.1. As a reminder, Figure 6.7.1 illustrates a normal distribution with different parameter values. To perform the Monte Carlo simulation, numerous samples (perhaps 500) would be drawn from the relevant distributions, each to form a single example case, and then Equation 6.5.2 applied to calculate life cycle costs for that case. The result would be numerous observations of possible life cycle costs.
Many software programs easily accommodate Monte Carlo simulation, including the Excel spreadsheet and Matlab. These software programs have regular functions or subprograms to generate random samples from input distributions. Monte Carlo simulations find use in a variety of application domains beyond infrastructure management, including environmental life cycle assessment and production planning. While Monte Carlo simulation explicitly considers uncertainty with stochastic inputs, it is crucially dependent upon the correctness of these input assumptions and modelling the effects of inputs. Accurately knowing the distributions of infrastructure costs and usage is unlikely. Users of Monte Carlo simulation should be aware of the classic computer adage: ‘garbage in, garbage out.’ Just because the results come from a complicated computer program, inaccurate inputs will not result in accurate results.
Another approach to exploring the effects of uncertainty is to use scenario and decision analysis. For our roadway cost example, scenario analysis might pertain to major underlying usage influences or natural disasters. For example, new industrial development in the roadway vicinity may result in much larger usage and faster pavement deterioration. As another example, major rehabilitation may be required in the case of earthquakes. Each of these situations may be a different scenario with different life cycle costs as a consequence. The scenarios might each have a Monte Carlo simulation analysis with different assumptions about input distributions.
Decision analysis would go further and include probabilities associated with different scenarios. Each scenario might also have different assumptions about future actions, such as a decision to widen the roadway in connection with a rehabilitation action. For this decision analysis approach, common applications would include both cost and benefit assessments to evaluate net present value effects.
6.08: Chapter 6 Excercises
P6.1 (4 pts)
Suppose you have an electric powered building water heater.
a. Graph the Short Run Total Cost (SRTC) and the Long Run Total Cost (LRTC) of a water heater.
b. Suppose you have an electric water heater and your utility introduces variable pricing by time of day. How do you minimize cost of providing your hot water needs?
P6.2 (16 pts)
Develop a life cycle cost estimate for the differences between compressed gas (CNG) and bio-diesel (B20) alternative buses. We can ignore drivers and other overhead expenses since they are the same for the two vehicles. Use the following data:
• Bus purchase: \$ 342,366 for CNG, \$ 319,709 for B20.
• Assume 12 year life, with 37,000 miles per year of operation.
• Assume average speed of 12.72 mph, 3.27 mpg for CNG (where 1 gal = 126 cu.ft. NG) and 3.80 mpg for B20.
• Assume CNG is \$ 2.00 per gallon and B20 is \$ 3.00 per gallon in current dollars.
• Assume maintenance cost of \$ 9,000 per year for CNG bus and \$ 7,000 for B20.
• Assume a discount rate of 4%.
a. What is the annual operating cost of the two buses (excluding drivers and other overhead items)?
b. What is the net present value of the two buses’ cost streams?
c. What is the annualized uniform cost of the two buses?
d. What is the annualized cost per mile of the two buses?
e. Assuming 40 seats per bus, what is the annualized cost per seat-mile of the two buses?
f. What would be the impact on net present value of the cost differences if CNG doubled in price? What if both CNG and bio-diesel doubled?
g. Capital costs for buses are usually 100% subsidized and do not appear in the agency operating costs. How much is the annualized cost per mile of the two buses excluding capital costs?
h. Suppose that a driver and other expenses added \$ 50. per hour to operating costs. How many riders would be needed to cover the costs of the cheaper of these buses for the 28X route? (Assume a one hour, 20 mile trip and a fare per rider of \$ 3.25).
6.09: Chapter 6 References
References | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/06%3A_Performance_Usage_Budget_and_Cost_Functions/6.06%3A_Long_Run_Investment_Decisions_and_Cost_Functions.txt |
Infrastructure managers may go long periods of time without significant failures, extreme events or security breaches occurring for their infrastructure. However, a manager must be prepared to deal with such events and should plan ahead to mitigate the potential costs of such events. This chapter discusses approaches to prepare for and to mitigate the damages of such events.
The list of potential adverse events is long indeed:
• Critical infrastructure failure, such as electricity, water supply, telecommunications, etc.,
• Extreme events, such as earthquakes, fires, floods, hurricanes, landslides, lightning strikes, tornadoes, etc., and
• Security problems, such as bombs, guns, computer hacking, riots, etc.
News media regularly report such events throughout the world on a daily basis. Even the resignation or retirement of an employee with critical management knowledge can reveal a lack of resiliency in management.
While the chance of occurrence for any of these events is quite low in any particular year, the probability is typically not zero. The exception might be physically impossible occurrences such as flooding to a facility at the top of a hill (but then the top of the hill may be more prone to have high wind!). Figure 7.1.1 illustrates the estimates of probabilities of significant (magnitude greater than 6.7) earthquakes in California. The figure outlines the boundaries of California in white and the various earthquake fault lines show up as higher probability linear segments. The probability scale ranges from 10-6 (0.0001% chance per year) in blue to 10-2 (1% chance per year) in purple. While these particular estimates are uncertain, California infrastructure managers should be prepared for an earthquake event!
Even with a low probability of an event occurring, the number of repetitions of the underlying risk opportunity may result in a significant risk. For example, suppose your risk of falling from a scaffold is 0.1% in any particular day, which likely seems like a small risk to you. However, if you are on a scaffold 365 days a year, the probability of a fall over the course of a year would be (as discussed in Chapter 4):
$P_{r}\{f a l l\}=1-P_{r}\{\text { no } f \text { all }\}^{365}=1-0.69=0.31$
So you would have a 31% chance of a fall over the course of a year spent on scaffolding. Over fifteen years, the probability of a fall would increase to 99.6%. Similarly, riding a bike to and from work might have a low probability of experiencing a crash, but over a long period of time the likelihood of a crash increases. Better risk management might make changes such as safety straps on scaffolding or dedicated bike lanes. The result would be to lower the daily probability of an event considerably.
In addition to the chance of occurrence, the other dimension of risk management is to consider the severity of consequences for an event. A small flood may have some costs, but an organization could likely recover its infrastructure services rather quickly. In contrast, a large flood or a terrorist attack could have major consequences, including subsequent legal procedures. Similarly, small earthquakes or wildfires may have limited impacts, but a large earthquake or fire could require major rehabilitation or rebuilding.
Infrastructure managers should prepare for events with high frequency and low impact such as heavy rainstorms. For example, a large company with multiple oil platforms in the Gulf of Mexico should be prepared to secure and evacuate the platforms regularly due to hurricanes. But managers also need to prepare for high impact, low probability events such as earthquakes. Fortunately, high impact and high probability risks are rare. Also, low impact and small probability events are less of a concern than these other categories. Figure 7.1.2 illustrates the disruption probability and consequences for several organizational threats.
As an example, Figure 7.1.3 shows identified risks for water and wastewater systems.
Good infrastructure design and construction can significantly reduce the consequences of many risks. For example, earthquake resistant facility design has become required in earthquake prone areas. Similarly, adequate storm water systems (and good preventive maintenance) can reduce the risk of flooding. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/07%3A_Interdependence_Resiliency_and_Security/7.01%3A_Introduction.txt |
Infrastructure is interconnected, interdependent, and Complex. Infrastructure systems have complex connections and interdependencies that can lead to cascading failures. In many cases, infrastructure systems depend upon services provided by other infrastructure. For example, if the electricity supply is disrupted, then water supplies may be affected since pumps and treatment plants require electricity. If gasoline stations and oil pipelines depend upon the power grid for electricity, then transportation services may be disrupted. Second-order effects can also occur. For example, if electricity supply failure occurs and affects water supplies, then agriculture will be affected and eventually, banking and finance will have an effect. Figure 7.2.1 illustrates some of the interdependencies among six infrastructure services.
Geographic proximity can also result in infrastructure interdependencies. All the infrastructure on a flood plain may be vulnerable to a flood event. Similarly, an earthquake can disrupt multitude of infrastructure systems, including bridges, buildings, pipelines, electricity transmission lines, fiber optic cables, ports, and roadways.
Of course, infrastructure managers may be responsible for only one particular type of infrastructure. For example, a building manager usually relies upon the power grid for electricity, the local water supply utility for water, a telecommunications company for telephone and internet, and suppliers for a variety of resources. However, a building manager can estimate the likelihood and consequences of disruptions. Moreover, planning ahead can reduce the consequences of disruptions. Backup power systems for essential services (such as lighting) or back up communications capability can be installed in the building.
Modern communications and information technology has become pervasive in the provision of infrastructure services. Note that supervisory control and data acquisition (SCADA) and communications has the most occurrences among the interdependencies shown in Figure 7.1.3. Telecommunications companies need to be ready for rapid response to restore services in the event of disruptions to avoid cascading effects.
7.03: Improving Infrastructure Resiliency
Infrastructure resiliency is the capability to restore infrastructure to its original state after a disruption occurs. Improved resiliency can be achieved with planning for disruptions and having resources available to respond to disruptions. Figure 7.3.1 illustrates the various time periods. Prior to an incident or disaster, preparations can be made. At the time of an incident, the infrastructure performance degrades, especially as failures propagate through associated components. In extreme cases, the infrastructure performance may degrade to closure (so I would equal zero in Figure 7.3.1). A recovery period ensues until the infrastructure returns to normal performance.
Table 7.3.1 lists some strategies to improve resiliency along with technical, organizational, social and economic examples. The strategies are:
• Robustness may refer to facility design and construction but also includes good planning for emergencies and rehearsals.
• Redundancy includes strategies such as back-up power and lifeline resources such as food and water.
• Resourcefulness involves the resources that can be mobilized in response to an event.
• Rapidity is the speed at which restoration can occur.
Table 7.3.1: Technical, Organization, Social and Economic Dimensions of Infrastructure Resiliency. Source: O’Rourke, 2007. Redrawn and altered by Authors
Strategy Technical Organizational Social Economic
Robustness Appropriate building codes and construction procedures Emergency operations planning and practice Degree of community preparedness Regional economic diversification for supply
Redundancy Capacity for technical substitutions Alternative sites for managing emergency operations Availability of Housing options for disaster victims Investment in backup systems
Resourcefulness Availability of equipment and materials for response Capacity to improvise and innovate Capacity to address lifeline needs Capacity to improvise
Rapidity Restoration time Reduced Reaction Time Time to restore lifeline services Time to regain capacity
As an example of resiliency planning, consider an electricity utility. The utility can insure redundancy in transmission lines and power generation sources. Individual facilities can be design and built to withstand significant stresses. With major storms forecast, crews with equipment and supplies can be pre-positioned to respond to any outages rapidly. While the utility may still see disruptions, all of these activities will improve the resiliency of the utility.
Another example is planning for evacuation effectively. Figure 7.3.2 shows a 2005 evacuation of Houston due to forecast hurricane. During this evacuation, roadway lanes in to the city have been reversed to increase the available capacity. Unfortunately, the traffic volumes resulted in major traffic jams. Improved entry controls onto the highway could eliminate this type of jam.
Climate change and sea level rise are two factors that are increasing the importance of infrastructure resiliency. As average sea level increases, the likelihood of flooding increases. A variety of new strategies may be required, as with the response to Hurricane Sandy that flooded portions of the New York subway system.
Finally, the use of scenario analysis (as described in Chapter 6) may be useful for planning. A regular session to consider possible risks, preparedness, and documentation of procedures can be extremely useful. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/07%3A_Interdependence_Resiliency_and_Security/7.02%3A_Infrastructure_Interdependencies.txt |
Security has become a major concern for infrastructure managers. Infrastructure systems have been targets of terrorist attacks, such as the attack on building facilities using airplanes by agents of Al-Qaeda on September 11, 2001. Numerous other examples exist, such as bombs place in subway systems and railcars. Theft is also a security concern for infrastructure systems.
Responses to improve security have been widespread. Physical barriers have been erected to prevent vehicles or unauthorized individuals to come onto vulnerable infrastructure. Surveillance for suspicious activity has been increased. Communication protocols with law enforcement agencies have been refined.
For an infrastructure manager, the key questions to ask are:
What are the major risks facing my system?
• How can these risks be reduced?
• How much should be invested in security versus other resource needs?
The most frequent security threat is due to computer hacking. It is not uncommon to have numerous hacking attempts on a local network per day. Much of this activity is intended to reveal financial information, but some of it is malicious. As noted earlier, many infrastructure systems rely upon SCADA systems and communications software for operation, so the infrastructure services may be vulnerable to such attacks. Investment in good personnel and software protection is critical for such services.
7.05: Preparing for and Responding to Emergencies
Organizations should be prepared to respond to emergency situations. These situations may arise from a multitude of sources, including natural and man-made hazards. Large emergencies typically involve multiple infrastructure systems and large populations, so co-ordination with emergency services and managers is critical.
A few elements of preparation can be noted. First, a communications strategy should be in place. This strategy should include a means of communicating with infrastructure users and response personnel. For example, a broadcast strategy of emergency communications via email and text messaging should be in place. The broadcast mechanism should be regularly tested.
The second component of emergency preparation is a decision making strategy. Who is empowered to make decisions in the event of an emergency? Successors should also be identified in case the primary decision-maker is not available.
In an emergency, knowledge of available resources may be critical. Where and what resources and emergency supplies are positioned can be important information to aid effective decision making.
As noted earlier, pre-positioning personnel, equipment, and supplies can be a very effective preparation strategy. Temporary bridges, transformers, power lines and the like can be all readied for rapid deployment.
Temporary facilities may also be needed for emergency operations. Shelters can be assembled for individuals made homeless by fires or other destruction. Dirt runways can be used for the delivery of emergency supplies by air. Temporary cellular telephone and Wi-Fi stations can be moved in and installed rapidly.
Response to emergencies generally requires immediate attention from all the members of the infrastructure management team. Innovation, coordination and rapid decision making are necessary elements of a successful response!
7.6.01: Chapter 7 References
P7.1 (10pts)
Using the latest EPA E-GRID ‘Power Flows’ spreadsheet available on the internet, you will find electricity export and import estimates for all of the states in the US.
a) What are top 5 importing and exporting states in terms of GWh? What about in terms of percent of state consumption? What are the reasons why states may import significant amounts of electricity?
b) Focus on the twelve Western United States. Does the western grid region come close to providing a 'zero balance' of imported and exported power? If not, what might be the cause of the net import or net export of this entire region?
c) Make a small optimization model to estimate the power flows in the 12 Western US states (i.e. try to match up the importing and exporting states and make the overall power flow balance). If necessary, use import/export data for a ‘super’ region located near Chicago to help your balance. Make a summary table, spreadsheet, etc. that shows where states get their imported power from (or export to). Assume that utilities try to minimize the transport cost of electricity, which is roughly proportional to distance between states; you can use a rough estimate of distance accurate to the nearest 500 miles. Report your results as a matrix in which entries represent the estimated flow between states and column and row totals represent exports and imports of power given from e-grid.
d) Let us simulate a storm along the west coast, with all transmission capability among WA, OR and CA knocked out (so these three inter-state distributions are set to zero. Other inter-state distributions are ok as well as in-state generation.). Re-estimate your flows for this case. What has changed, if anything?
7.06: Chapter 6 Excercises
References
• Committee on Increasing National Resilience to Hazards and Disasters, (2012), Disaster Resilience: A National Imperative, National Academies Press. https://www.nap.edu/catalog/13457/di...nal-imperative
• Field, E.H., Biasi, G.P., Bird, P., Dawson, T.E., Felzer, K.R., Jackson, D.D., Johnson, K.M., Jordan, T.H., Madden, C., Michael, A.J., Milner, K.R., Page, M.T., Parsons, T.,113
• Powers, P.M., Shaw, B.E., Thatcher, W.R., Weldon, R.J., II, and Zeng, Y., 2013, Uniform California earthquake rupture forecast, version 3 (UCERF3)—The time-independent model: U.S. Geological Survey Open-File Report 2013–1165, 97 p., California Geological Survey Special Report 228, and Southern California Earthquake Center Publication 1792, http://pubs.usgs.gov/of/2013/1165/.
• National Research Council (2009) Sustainable Critical Infrastructure Systems: A Framework for Meeting 21st Century Imperatives, National Academies Press, http://www.nap.edu/catalog/12638/sus...g-21st-century
• O'Rourke, T.D., 2007. Critical infrastructure, interdependencies, and resilience. BRIDGE-WASHINGTON-NATIONAL ACADEMY OF ENGINEERING-, 37(1), p.22.
• Rinaldi, Steven M., James P. Peerenboom, and Terrence K. Kelly. "Identifying, understanding, and analyzing critical infrastructure interdependencies." IEEE Control Systems 21.6 (2001): 11-25.
• Sheffi, Yossi. "Building a resilient organization." BRIDGE-WASHINGTON-NATIONAL ACADEMY OF ENGINEERING- 37.1 (2007): 30.
7.07: Chapter 7 References
References
• Committee on Increasing National Resilience to Hazards and Disasters, (2012), Disaster Resilience: A National Imperative, National Academies Press. https://www.nap.edu/catalog/13457/di...nal-imperative
• Field, E.H., Biasi, G.P., Bird, P., Dawson, T.E., Felzer, K.R., Jackson, D.D., Johnson, K.M., Jordan, T.H., Madden, C., Michael, A.J., Milner, K.R., Page, M.T., Parsons, T.,113
• Powers, P.M., Shaw, B.E., Thatcher, W.R., Weldon, R.J., II, and Zeng, Y., 2013, Uniform California earthquake rupture forecast, version 3 (UCERF3)—The time-independent model: U.S. Geological Survey Open-File Report 2013–1165, 97 p., California Geological Survey Special Report 228, and Southern California Earthquake Center Publication 1792, http://pubs.usgs.gov/of/2013/1165/.
• National Research Council (2009) Sustainable Critical Infrastructure Systems: A Framework for Meeting 21st Century Imperatives, National Academies Press, http://www.nap.edu/catalog/12638/sus...g-21st-century
• O'Rourke, T.D., 2007. Critical infrastructure, interdependencies, and resilience. BRIDGE-WASHINGTON-NATIONAL ACADEMY OF ENGINEERING-, 37(1), p.22.
• Rinaldi, Steven M., James P. Peerenboom, and Terrence K. Kelly. "Identifying, understanding, and analyzing critical infrastructure interdependencies." IEEE Control Systems 21.6 (2001): 11-25.
• Sheffi, Yossi. "Building a resilient organization." BRIDGE-WASHINGTON-NATIONAL ACADEMY OF ENGINEERING- 37.1 (2007): 30. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/07%3A_Interdependence_Resiliency_and_Security/7.04%3A_Infrastructure_Security.txt |
Contract and workflow management are often major time commitments for infrastructure managers. Contract management is the process of ordering and monitoring outside organizations to do some work required for infrastructure management. Workflow management is the process of organizing and scheduling tasks related to infrastructure management. The extent to which tasks are contracted out will depend upon the internal resources available for infrastructure management.
As with many processes, information technology aids are available and useful for both contract and workflow management. As tasks are defined, they can be logged into a database, monitored and progress recorded. Contract documents and records are quite likely to be kept digitally by both the principal and the contractor. Either specialized or general purpose software can be used for these purposes.
Of course, contract and workflow management is not limited to the domain of infrastructure management. Large firms such as Amazon have very sophisticated financial, inventory and order tracking software. The transportation provider firm Uber has large numbers of contractor drivers as well as suppliers. Similarly, hospitals have systems in place for contracting and workflow management. We will focus on contracting and workflow management for infrastructure, although the processes are similar for other applications (Monczka et. al 2015; Van Der Aalst and Kees, 2004).
8.02: Contract Management
Contracting with outside organizations to perform infrastructure management tasks is both common and useful. Contracting has several advantages relative to performing all tasks within the infrastructure owner organization:
• Can provide more resources for peak work period demands. For example, major rehabilitation projects require significant resources of equipment and manpower which are typically beyond the regular resources in an ongoing infrastructure management organization. As a result, rehabilitation work is usually contracted out.
• Can provide access to specialized knowledge and equipment. Outside organizations can specialize in a particular area such as elevator or roof inspection, for which expertise is not needed year-round for the infrastructure management organization. Similarly, road repaving is generally contracted out rather than maintaining specialized paving equipment in a municipality.
At the same time, contracting incurs costs for contact management and payments of profits to contractors.
Contracts come in a bewildering variety of forms. They can have many different payment terms and risk allocation provisions (Hendrickson, 2007). They typically vary between countries, organizations, and types of work. They are also subject to complex legal forms and reviews. By and large, actual contract documents are prepared by a legal department or a professional organization and contract provisions are re-used extensively, so individual infrastructure managers do not need to draft new contract documents.
The important stages in contracting are shown in Figure 8.1 and discussed briefly below. Not all of these stages will occur in every contracting process. For example, contract modifications may not be required in many cases.
1. Requirements definition is a process to specify the work desired from the contractor. For a major rehabilitation project, this definition may require a significant component design process.
2. Contracting strategy formulation is a series of decisions about the contracting process, such as pricing and time frame requirements.
3. Pre-Qualification is a process of selecting a group of potential contractors. Pre-qualification may be a subjective judgment by a manager or maybe a formal process of application and qualification reviews. In many cases, infrastructure managers may have long term relationships with contractors and build up confidence and trust in their capabilities.
4. Request for a quote or proposal from potential contractors. The request will usually include pricing parameters and the desired time frame for the work. Pricing options include fixed price, cost plus profit, guaranteed maximum price, and unit cost. Unit cost pricing is useful for ongoing contracts with numerous tasks. For example, a unit cost pricing for roadway repaving might have a price per lane-mile of repaving.
5. Negotiation and selection of a contractor can take many forms. A classic, competitive fixed bid approach receives monetary bids from pre-qualified contractors and awards the work on the basis of lowest costs. The infrastructure manager may also negotiate terms with multiple potential contractors and eventually award the contract to the most desirable terms.
6. Inspection and Quality Assurance is a post-award task to insure that the work is done to the desired requirements.
7. Contract modification is a common process. During the course of work, the desired requirements may change or unforeseen circumstances dictate different approaches. Contractors will typically be willing to negotiate contract modifications in response.
8. Payments and reporting are processes that make periodic and final payments to contractors as well as documenting the entire process.
Allocation of risks between contractors, owners and other interest parties is an important issue in contracting. Risk allocation becomes important whenever unexpected events occur. For example, the required work may be more extensive than originally expected and then the question arises: who will pay for the extra work? A partial list of responsibilities with concomitant risk that can be assigned to different parties would include (Hendrickson, 2007):
• Force majeure (i.e., this provision absolves an owner or a contractor for payment for costs due to "Acts of God" and other external events such as war or labor strikes).
• Indemnification (i.e., this provision absolves the indemnified party from any payment for losses and damages incurred by a third party such as adjacent property owners.).
• Liens (i.e., assurances that third party claims are settled such as "mechanics liens" for worker wages).
• Labor laws (i.e., payments for any violation of labor laws and regulations on the job site).
• Differing site conditions (i.e., responsibility for extra costs due to unexpected site conditions).
• Delays and extensions of time.
• Liquidated damages (i.e., payments for any facility defects with payment amounts agreed to in advance).
• Consequential damages (i.e., payments for actual damage costs assessed upon impact of facility defects).
• Occupational safety and health of workers, including insurance provisions and payments in the event of safety damages.
• Permits, licenses, laws, and regulations. It is often difficult to know exactly what permits may be required.
• Equal employment opportunity regulations.
• Termination for default by contractor.
• Suspension of work.
• Warranties and guarantees.
8.03: Workflow Management
Infrastructure management involves long term cycles of asset management planning and implementation, often for periods of a year or even longer. But another aspect of infrastructure management is dealing with the day to day desired work tasks. For example, on a military base, a campus or a large building, there will be requests for repair and re-stocking tasks as well as scheduled activities such as inspection and maintenance. Workflow management is the process of identifying these tasks, assigning tasks to workers (or contractors), setting priorities among tasks, and documenting the resulting work. Analysis of workflow tasks is also a useful activity, as problems can be identified (e.g. which elevator is breaking down most often?) and worker productivity monitored.
Work tasks may have a variety of forms and involve distinct skills. For example, author Don Coffelt’s facility management group provides the following services to campus departments:
• Heating and air conditioning
• Carpentry
• Custodial services
• Roof and gutter repair
• Electrical repairs
• Window washing
• Elevator maintenance
• Gardening
• Pest Control
• Plumbing
• Meeting setup
• Trash and recycling
• Painting
• Locksmith
In addition to service requests from departments, there are a large number of tasks generated from the facilities management group itself, such as ice and snow clearance and preventive maintenance. Figure 8.3.1 illustrates a typical preventive maintenance task, in this case clearing debris from a stormwater sewer sump. Departmental payments may also be required for work flow tasks, such as changing locks in the events of lost or misplaced keys.
Setting priorities among tasks is an important component of workflow management strategy. If tasks are simply handled in a first come, first served basis, then critical tasks such as safety hazards may be neglected. At the same time, a general buildup of unfulfilled tasks may require special efforts to catch up, such as contracting out more tasks or hiring more staff.
As with many aspects of infrastructure management, software and communication aids are available for workflow management. Service requests can be made directly and digitally, rather than using paper or telephone requests. Task completion can be documented by workers using mobile devices. Databases can track the status of tasks. Geographic information and computer aided design software can help route planning or identifying problem areas.
8.04: Chapter 8 Excercises
P8.1 (4 pts)
Find a contract that you participate in (such as a telephone or a utility service contract). Read the contract and prepare a summary of the parties responsibilities and options in your own words.
P8.2 (4 pts)
Regulatory compliance is an increasingly important component of infrastructure contracting. Research and report on one progressive contracting element. Examples include “job order”, “performance fee”, “design build” and “term service” contract models.
8.05: Chapter 8 References
references
• Hendrickson, Chris (2007) Project Management for Construction, http://pmbook.ce.cmu.edu/
• Monczka, Robert M., Robert B. Handfield, Larry C. Giunipero, and James L. Patterson. Purchasing and supply chain management. Cengage Learning, 2015.
• Van Der Aalst, Wil, and Kees Max Van Hee. Workflow management: models, methods, and systems. MIT press, 2004. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/08%3A_Contract_and_Workflow_Management/8.01%3A_Introduction.txt |
Commissioning is a process of transforming a completed construction project into a functioning and useful infrastructure system. The construction project might be a completely new facility, a major new piece of equipment, a facility addition or major rehabilitation. The tendency of construction project managers is to focus on simply completing the construction process itself. Commissioning is intended to ensure that the new construction operates as planned and that the new facility can continue to operate with regular infrastructure management. So commissioning is important although likely infrequent activity for infrastructure managers.
New facilities can be quite complex, with a variety of systems needed to be commissioned. Electronics, mechanical equipment, software controls, and even components such as windows need to be tested and operation plans for asset management developed. An example of a complicated machine room is shown in Figure 9.1.1.
For larger projects, a specialized manager for the commissioning process may be retained. This manager would be responsible for insuring that all the major commissioning tasks are completed adequately. A challenging aspect of the commissioning agent’s job is that the construction organization(s), the infrastructure manager, the facility users and the facility owner must all be satisfied and involved.
Major steps in the commissioning process include:
1. Preparation and planning involves identifying tasks, individual responsibilities and required documentation.
2. Completion and integrity testing involves a comparison of as-built and as designed plans, often using computer-aided design or facility information models.
3. Operational testing involves preliminary testing of equipment and software as built in the facility. This initial testing may rely upon construction or equipment supplier professionals, but should also involve the future operators of the equipment.
4. Start-up and Initial Operation involves actual use of the facility with monitoring to ensure that the new facility is operating as planned.
5. Performance testing occurs during use to assess the overall performance of systems such as heating, ventilating and air conditioning systems in new buildings.
6. Post commissioning occurs when the regular infrastructure management procedures are in place and operating smoothly.
Of course, commissioning may not always go smoothly, and additional construction or adjustment tasks might be required in addition to the steps outlined above.
9.02: Testing New Facilities
Adequately testing the systems in new facilities can be difficult. While turning a system on will reveal basic operating information, it does not provide a test of operation under the various conditions that the facility will encounter during years of service. Moreover, some systems are intended for operation under extreme conditions of heavy rain, high wind or fire. Testing under these conditions would be costly and hazardous! For most commissioning procedures, testing of all operational modes is normal but usually not under all field conditions. For example, heating, ventilating and air conditioning in a new building would all be tested, even if only heating was required at the time of testing.
Some special tests that would not be part of normal operations may also be useful. For example, a fan pressurization test may be performed on a new building. With a higher pressure in the building provided by a fan, the extent of air leakage can be measured as the flow required to maintain the pressure differential. Figure 9.2.1 shows some possible features that could have air leakage and might be addressed as part of the final construction and commissioning activities. As another example, emergency vehicles might test new tunnels for any problems (either virtually in three-dimensional models or in reality). | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/09%3A_Commissioning_New_Facilities/9.01%3A_Introduction.txt |
Documentation of the new facility is an important part of commissioning. The manufacturer and construction personnel will be passing system control over to the infrastructure management organization, and they may not be familiar with the intricacies of the new facility.
Three-dimensional computer-aided design or facility information models are usually prepared prior to new facility construction. However, there are often modifications to the original design during the course of construction. As a result, as-built three-dimensional models are often required for commissioning and are useful subsequently for infrastructure management. As-built models may require field measurements and specialized companies or groups to prepare.
Equipment documentation for operation, maintenance, and parts are also assembled as part of the commissioning process. While this documentation was on paper in the past, more and more documentation is available digitally. This has the advantage of providing immediate access to documentation in the field.
9.04: Integrating New Facilities into Infrastructure Management
A final commissioning task is to integrate new facilities into the regular practice of infrastructure management. Fortunately, most new facilities are provided in excellent condition, so the regular cycle of condition assessment, deterioration modelling, and maintenance/rehabilitation may not be immediately needed.
One aspect of integration is to ensure that the actual occupants or users of the new facilities are familiar with the various idiosyncrasies of the facility. Where are exits and elevators? Where are emergency supplies and first aid kits? Are offices and rooms set up in the most effective fashion?
Figure 9.4.1 shows the recommended transition steps for the commissioning of the Boston Central Artery/Tunnel (also known as the ‘Big Dig’) (Committee, 2003). This very large project replaced an elevated roadway with tunnels and added several new bridges and routes in Boston, Massachusetts. This new facility would be owned and operated by the Massachusetts Turnpike Authority (MTA), but the construction itself was largely contracted out, including a large project management team. As noted in Figure 9.4.1, an external review panel urged the MTA to adopt strategic thinking about the commissioning process needed during the transition to operations. This transition would also require a public education program to familiarize the traveling public with the new system.
Commissioning is an ongoing and continuous activity that forms an important component of the asset management process as described in chapter 2. Properly implemented, commissioning improves building performance, energy efficiency and sustainability over the life of the asset. The “commissioning”, “retro-commissioning”, “continuous commissioning” processes include multiple, overlapping activities as illustrated in Figures 9.4.2 and 9.4.3 below.
9.05: Chapter 9 Exercises
P9.1 (10 pts)
Define “Commissioning” in terms of Building Commissioning, Retrocommissioning and Recommissioning. How might they differ in terms of process and objectives?
P9.2 (5 pts)
Describe a technology solution to new/existing facility documentation?
P9.3 (5 pts)
Summarize commissioning’s effects on reduce energy costs and greenhouse gas emissions.
9.06: Chapter 9 References
References
• Committee for Review of the Project Management Practices Employed on the Boston Central Artery/Tunnel (‘Big Dig’) Project, (2003) ‘Completing the Big Dig: Managing the Final Stages of Boston Central Artery/Tunnel Project,’ National Academies Press, http://www.nap.edu/read/10629/chapter/1.
• Building Commissioning: A Golden Opportunity For Reducing Energy Costs and Greenhouse Gas Emissions in the United States. Mills, E. Energy Efficiency (2011) 4: 145. doi:10.1007/s12053-011-9116-8
• Lawrence Berkley National Lab: BUILDING COMMISSIONING, A Golden Opportunity for Reducing Energy Costs and Greenhouse-Gas Emissions cx.lbl.gov/definition.html (accessed January 2017).
• Parrish, Kristen, and et. al. “Improving Energy Efficiency through Commissioning.” Energy Technologies Area, Oct. 2013, eta.lbl.gov/publications/improving-energy-efficiency-through. Accessed 9/30/2017. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/09%3A_Commissioning_New_Facilities/9.03%3A_Documenting_New_Facilities.txt |
A road is an identifiable route or path between locations. Nearly all roads are constructed in some way, typically by smoothing the natural landscape and often by paving. Roads serve as transportation routes, accommodating bicyclists, horses, vehicles, and pedestrians. Roads also provide access to property and provide right-of-way to other infrastructure systems such as pipelines or telecommunications cables. Reflecting on the ubiquity and importance of roads, there are many words denoting roadways, including: avenue, boulevard, court, drive, freeway, highway, parkway, street, etc.
Roadway construction dates back over 6,000 years. Early roads were paved with timber, brick and stone. The Roman Empire was noted for an extensive network of paved roadways, covering roughly 78,000 km in Europe and North Africa 2,000 years ago. Figure 11.1.1 shows a modern picture of former Roman road paved with stone and still in use in Syria.
Roads can be one-way, but most are divided in the center and accommodate two-way traffic. About a third of worldwide roadway traffic follows the convention of vehicles traveling on the left side of roadways, while two-thirds follow a right-side convention, including the United States (Figure 11.1.2).
Modern pavements are complex systems themselves, with multiple layers and drainage systems. Figure 11.1.3 illustrates a flexible (asphalt) pavement used for rural interstates in Idaho. The pavement has a surface layer of asphalt (six inches of plant mix bituminous pavement), a layer of asphalt treated permeable leveling course (two inches of ATPLC), gravel, a rock cap, a granular subbase, and a subgrade geotextile. The pavement is slanted to facilitate rain run-off.
Roadways are used for numerous purposes and by multiple types of vehicles. Table 11.1 shows vehicle miles travelled (in millions) for different types of vehicles and types of roadways. Limited access interstate roadways have significant amounts of traffic, but most traffic is carried on other types of roadways. Motorcycles, buses and truck traffic are significantly smaller than light duty vehicle traffic.
Table 11.1.1: U.S. Vehicle Miles Traveled by Type of Vehicle and Type of Roadway 2014.
Roadway Type Light-Duty Vehicle (million miles) Motorcycles (million miles) Buses (million miles) Trucks (million miles) All Vehicles (million miles)
Rural Interstate 173,000 1,000 2,000 56,000 231,000
Other Rural 505,000 6,000 4,000 76,000 690,000
Urban Interstate 458,000 2,000 2,000 57,000 520,000
Other Urban 1,476,000 11,000 8,000 90,000 1,585,000
Total 2,711,000 20,000 10,000 279,000 3,026,000
Source: FHWA, Public Domain, Highway Statistics, https://www.fhwa.dot.gov/policyinfor...s/2014/vm1.cfm
11.02: Duration and Extent of Roadway Infrastructure
Roadways are widespread throughout the world. As an example, Figure 11.2.1 shows the mileage of rural and urban highways in the United States from 1950 to 1997. Rural roadways are much more extensive than urban roadways, even though the bulk of population resides in urban areas. Unpaved roadways have declined, while the total mileage of roadways has shown a modest increase over the past fifty years. In 1997, US population was roughly 270 million, representing 68 people for every mile of roadway. Not included in these highway totals would be a variety of trails, temporary roads for uses such as logging, or ‘natural’ roadways such as truck pathways on frozen lakes and rivers.
More recent trends in US public road mileage, lane miles, and overall vehicles miles of travel are shown in Figure 11.2.2 for 1980 to 2014. Overall mileage has changed very little in this period, while lane-miles have increased slightly suggesting that lanes have been added to existing roadways. In contrast, vehicle miles of travel have increased significantly in this period, suggesting congestion has also been increasing. Note that the left vertical axis for road mileage and lane-miles starts at three million miles rather than zero.
The durability of roadways and roadway components can vary considerably. Rights of way can exist for hundreds of years, especially if a roadway is in regular use. Pavements and other roadway components are not so longed lived, as discussed in Chapters 2-4.
Roadway surfaces deteriorate with use and weathering. Deterioration from use is correlated to the weight of vehicles or, more precisely, the weight of vehicle axles. The effect of additional tire weight is non-linear, with damage increasing by roughly a power of four. Roadway traffic is often measured in ‘equivalent single axle loads’ (ESAL) where the standard single axle load is 18,000 lb (8,200 kg). Figure 11.2.3 shows approximate ESAL values for typical vehicles. Buses tend to have higher loads because they have fewer axles than most trucks.
Pavement design, construction and maintenance are also critical elements affecting the durability of roadways. Stronger and thicker paving material with a good foundation is generally expected to last longer than weaker pavements. However, the initial costs of highly durable pavements may be difficult to justify for low volume roadways. Effective pavement lifetimes are roughly 10 to 50 years. Typical paving materials include hot mix asphalt, concrete, and bituminous surface treatment. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/11%3A_Roadway_Infrastructure/11.01%3A_Introduction.txt |
Roadways are owned and managed by local governments, national governments, and private entities. These different groups often have complicated partnership arrangements in which multiple parties may contribute financing, standards, or other resources. The different groups may have very different objectives. For example, a national government may wish to promote inter-state transportation, whereas a local 144
government may be primarily oriented towards providing roadway services for local businesses and residents.
Users provide the bulk of funding for roadways, with some revenues coming from general government revenues. Common means of securing revenues include:
• Tolls directly on roadway use, usually varying by distance traveled and type of vehicle. Electronic toll collection using RFID tags is becoming more common.
• Vehicle registration fees, usually imposed on an annual basis. These fees may be applied to roadway construction, management processes (including police) or be diverted to general government revenues.
• Fuel taxes applied on volumes of fuel purchases. Figure 4 shows the combined local, state and federal taxes in different states in the United States in 2008. European fuel taxes tend to be higher than those in North America, whereas fuel taxes are low or non-existent in some countries.
• Vehicle sales taxes, although these taxes may flow to general government revenues rather than be dedicated to roadways.
• Property taxes may be used by local governments to provide local roadways.
• Fines such as parking violation fees may be used by local governments.
Figure 11.3.1 summarizes the sources of revenue for highways in 2010. Note that bond revenue must be eventually repaid as the bonds mature. Expenditures by type are shown in Figure 11.3.2. The capital outlay shown in Figure 11.3.2 represents rehabilitation and some lane expansion for existing roadway infrastructure rather than new construction (as discussed above).
11.04: Some Infrastructure Management Issues for Roadways
Roadways provided an application domain for the early development of asset and infrastructure management methods and systems. Since roadways are so widespread and long-lasting, adopting a life cycle viewpoint for design and maintenance decisions has been widespread but not universal. Bridge and road management systems are among the best developed software systems to aid infrastructure management. Examples include the Pontis bridge management system from AASHTO (1997), PAVER from the USACOE (Shahin, 2016), and HDM from the World Bank (Watanatada, 1987). Each of these tools involves comprehensive inspection and inventory data gathering as well as aids for decision making. The tools evolve with changing needs, conditions, more experience, and more research.
Roadway congestion is a continuing cost and difficulty with roadway management throughout the world. As shown in Figure 11.4.1, even inter-urban roadways are showing the effects of congestion.
Figure 11.4.2 shows the different sources of roadway congestion in the US. The largest category is bottleneck roadway sections, followed by traffic incidents (such as vehicle breakdowns or crashes), and bad weather (such as snow or flooding). Work zones for roadway management activities are also a major source of congestion.
Roadway renovation is a continuing problem in many countries. Projects are expensive and disrupt normal travel patterns. Novel contracting schemes to speed projects have been introduced, such as charging for closure of roadways per day. New materials can also reduce the costs of renovation.
Environmental concerns for roadways are becoming more common. The costs associated with urban sprawl and climate change reflect the dependence on motor vehicles and petroleum fuels. While there has been considerable success in reducing conventional air emissions from motor vehicles (Figure 11.4.3), greenhouse gas emissions are a major concern. This concern has resulted in new greenhouse gas emissions standards as well as promotion of alternative fuels such as battery electric vehicles powered by renewable power generation.
Safety also remains a significant issue for roadway infrastructure. Figure 11.4.4 shows fatality rates per capita in different countries of the world. Countries clearly differ in the risk of vehicle crashes. For roadway management purposes, normalization by vehicle miles of travel is likely more useful than fatalities per capita as in Figure 11.4.4. However, many countries do not report total vehicle miles of travel. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/11%3A_Roadway_Infrastructure/11.03%3A_Institutional_Arrangements_for_Roadway_Infrastructure_Management.txt |
P11.1 (6 pts)
How would you design vehicle fees for different types of vehicles to account for different impacts on pavements? How does your suggested design compare to existing fees?
P 11.2 (6 pts)
The federal government collects diesel and gasoline taxes and puts them in the Highway Trust Fund. (a) How would you recommend that these funds be allocated among the different states? (b) Would you allocate any of the funds for public transit? (c) How might you tax (or should you tax) battery powered vehicles?
P 11.3 (14 pts)
Suppose I have a simple network as shown below. I have 300 vehicles going from A to B, and they can either take route A-B or route A-C-B. The travel time per vehicle on route A-B is 10 + 0.5 qAB min where qAB is the travel volume on route AB. The travel time per vehicle on route A-C-B is 15 + 0.2 qACB min.
a. Suppose vehicles chose routes such that any route that was used from A to B had equal travel times. This is called a ‘user equilibrium’ since no single user has an incentive to change routes as there is no opportunity to save time by doing so. What are the travel volumes on the two routes for a user equilibrium?
b. Suppose vehicles are assigned to particular routes to minimize the total travel time on the network. The resulting pattern is called a ‘system equilibrium’ since changing a route can only increase overall system travel times. What are the travel volumes on the two routes for a system equilibrium?
c. Why do the system and user equilibrium flow volumes differ?
d. Suppose travelers have a value of time of \$ 1/6 per minute per vehicle. For example, if a toll p was imposed on route A-B, the effective travel time would be 10 + 0.5*qAB + 6*p. Is there a toll we could impose somewhere on the network that would be a user equilibrium but have the system equilibrium route volumes? What is it? What is the resulting revenue?
e. Using the value of time in part d, what is the dollar value of the difference between user equilibrium and system equilibrium?
f. Suppose we have to do roadway maintenance and shut down link A-B in the network, diverting all traffic to route A-C-B. What would be the travel time on this route? Comparing this to the base user equilibrium (in part a), what is the increase in travel time? Using the value of time in part d, what is the increase in user cost?
g. Roadway renovation contracts often use a system called ‘A+B’ in which contractors bid’s include a ‘rental fee’ for closing roadways (that is the +B, whereas A would be the estimated renovation costs themselves). In the case of our small network, this +B amount might be represented by your answer to part f. In practice, the +B amount would be calculated from a typical value of time, volume on a roadway, and an estimate of the travel time increase from using alternative routes. What might be the advantage of the A+B contract system versus a conventional system (call it A) for infrastructure management? Do you think renovation costs overall would go up or down with the A+B system? (Hint: the table below is an example from WSDOT, with C being the winning, low bidder).
Contractor A B C
A Bid Amount \$4,300 K \$4,900 K \$4,450 K
No. Days Bid 130 110 115
Road User Cost \$12 K \$12 K \$ 12 K
Combined A+B Bid \$5,860 K \$6,220 K \$5,830 K**
11.06: Chapter 11 References
references
• AASHTO, Pontis Release. "3.2 Users Manual." American Association of State Highway and Transportation Officials, Washington, DC (1997).
• FHWA (2016) 2013 Conditions and Performance Report, https://www.fhwa.dot.gov/policy/2013cpr/index.cfm.
• Haas, Ralph, W. Ronald Hudson, and John P. Zaniewski. Modern pavement management. 1994.
• Shahin, M. Y., and Micro PAVER Version. "5.3 User Manual." US Army Corps of Engineers, ERDC-CERL.
• Watanatada, Thawat, ed. The Highway Design and Maintenance Standards Model: User's manual for the HDM-III model. Vol. 2. Johns Hopkins University Press, 1987. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/11%3A_Roadway_Infrastructure/11.05%3A_Chapter_11_Exercises.txt |
Buildings are constructed to support and protect activity and artifacts. Buildings may incorporate natural structures, such as the document storage and server farms housed in rooms within a large, underground limestone mine owned by Iron Mountain in Pennsylvania. While human buildings are quite prominent, many animals engage in building activities for nests, hives, etc.
While buildings may be relatively simple structures, most include other systems providing quite extensive functionality, including:
• Electricity distribution and lighting, typically using alternating current of 110 to 220 volts.
• Water distribution and heating for human use.
• Waste disposal systems for solid or liquid wastes.
• Heating, ventilation and air conditioning (HVAC) systems.
• Internal transportation systems, including elevators, escalators, and stairways.
• Kitchens for food preparation and storage.
• Security systems to identify and discourage intruders.
• Telecommunications systems for data transfer.
• Garages for parking vehicles.
Charging stations for battery electric and plug-in vehicles.
Buildings also have systems for emergencies and security. Fire alarms are often required by regulation. Signage for evacuation and emergency lighting is common. First aid supplies are common. Video cameras for security purposes are often installed.
12.02: Duration and Extent of Building Infrastructure
Building statistics often differentiate between commercial, residential and other types of buildings. Table \(1\) shows the 2003 distribution of commercial buildings in the United States with regard to size, use, and energy sources. The total inventory includes 4.6 million buildings. Not surprisingly, the number of buildings in each size category declines as size increases. Nearly all commercial vehicles have electricity, and most have other energy sources
Table \(1\) - Characteristics of Commercial Buildings in the United States 2003
Source: Statistical Abstract of the United States, 2008, Public Domain, ‘Commercial Buildings Summary,’ Table 968. https://www.census.gov/library/publi...n-housing.html
The numbers of housing units in the United States is shown in Table\(2\). The numbers of residential buildings would be smaller than the number of housing units since there are multi-unit buildings. Of the 124 million housing units in 2005, 76 million (or 61%) are single unit houses (Census, 2008). The numbers of housing units has been increasing over time, reflecting growth in population and a decline in the average size per household. The fraction of homes owned by residents has been increasing over time to 60% in 2005.
Table \(2\) - United States Housing Units 1980-2005
Source: Statistical Abstract of the United States, 2008, Public Domain, ‘Total Housing Inventory for the United States,’ Table 947. https://www.census.gov/library/publi...n-housing.html
Buildings tend to relatively long-lived types of infrastructure, with averages of 50 to 100 years not uncommon. Many buildings are demolished not due to deterioration, but due to functional obsolescence: building needs may change and replacing a building may become advantageous. The US Internal Revenue Service prescribes a depreciation lifetime of 20 years for farm buildings, 27.5 years for residential rental property and 39 years for nonresidential real estate (Treasury - https://www.irs.gov/pub/irs-pdf/p946.pdf). Figure \(1\) shows the reported age of US commercial buildings in 2012, with a median building age of 32 years. Within any building, components may be replaced more frequently, such as HVAC or roof replacements. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/12%3A_Building_Infrastructure/12.01%3A_Introduction.txt |
Buildings may be owned by occupants (or residents) or investors of various kinds. As shown in Table 12.2.2, nearly 30% of US housing units are owned by investors and rented to occupants.
Ownership of buildings commonly changes over the building lifetime. Initially, buildings may be constructed with the intent of re-sale upon completion of construction, as with residential developers. Active real estate markets aid in the transfer of ownership during the lifetime of buildings. Opportunities to gain tax advantages through rapid depreciation of buildings can motivate relatively frequent building sales. With or without ownership changes, buildings typically undergo renovations and changes in function during their lifetime.
Lending institutions often make loans using real estate as collateral. In the event of default on the loans, the lending institution can foreclose and gain possession of the property. During construction of buildings, the value of buildings is problematic, so lending institutions typically charge more for construction loans than for mortgage loans secured by a complete building’s collateral.
Building management can be undertaken by a variety of parties, including owners, occupants or contractors. Automated aids for building management are typically less sophisticated than aids for other infrastructure systems, reflecting in part the diverse ownership of the building infrastructure.
12.04: Some Infrastructure Management Issues for Buildings
Buildings are large consumers of resources and producers of environmental impacts throughout the world. As a result of these impacts, buildings are receiving increasing attention to improve function, reduce costs and reduce environmental impact. At the same time, architectural interests are flourishing to promote ‘aesthetic’ designs. In addition, there is continuing concern to make buildings better at supporting the occupants through improved ventilation, noise control and temperature control.
As noted in Chapter 10, ‘Green buildings’ standards are becoming much more prevalent, with many entities committed to such buildings, including the US General Services Administration (GSA) (https://www.gsa.gov/portal/content/123747). The most common standard in the US is the Green Building Alliance’s (a private non-profit group) ‘Leadership in Energy and Environmental Design’ (LEED) (USGBC, 2016). It is based on a point award system for a checklist of possible design and construction activities. Prerequisites and credits are included in the categories of:
• Sustainable site characteristics
• Water efficiency
• Energy and atmosphere
• Materials and resources
• Indoor environmental quality
• Innovation in design
Buildings are certified to different levels of standards based on submitted documentation and the published point system. Achieving savings in energy inputs during the building operational phase is of particular interest in the design stages.
Building construction and management improvement are continuing targets for research and innovation. Active areas include computer aids (such as Building Information Modeling), lean construction practices, new materials, pre-manufactured components, building resiliency, and life cycle costing for management.
12.05: Chapter 12 Exercises
P12.1 (5 pts)
What are the differences between commercial and housing buildings that influence management practices and decision making?
P12.2 (10 pts)
Select a category of LEED credits and estimate their life cycle effect and cost for a typical building.
12.06: Chapter 12 References
References
• Census of the United States. Statistical Abstract of the United States (2008), ‘Housing Units by Units in Structure and State: 2005, Table 952.
• Coles, D., G. Bailey, and R. E. Calvert. Introduction to Building Management. Routledge, 2012.
• Energy Information Agency (2016), ‘Building Energy Data Book,’ buildingsdatabook.eren.doe.gov/.
• U.S. Energy Information Administration, Office of Energy Consumption and Efficiency Statistics, Form EIA-871A of the 2012 Commercial Buildings Energy Consumption Survey. www.eia.gov/consumption/comm.../2012/#b11-b14.
• RS Means Company. Building construction cost data. RS Means Company, 1996.
• U.S. Department of the Treasury, Internal Revenue Service. How to Depreciate Property." IRS Pub 946. https://www.irs.gov/pub/irs-pdf/p946.pdf .
• USGBC. “Better Building are our Legacy”. http://www.usgbc.org/leed#rating. Accessed 21 December 2016. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/12%3A_Building_Infrastructure/12.03%3A_Institutional_Arrangements_for_Building_Infrastructure.txt |
Water infrastructure is intended to provide water for a variety of uses, to remove and treat wastewater, to provide flood risk mitigation, to aid water navigation, to provide recreational opportunities and to generate electricity or power. Water is essential for human life, with humans comprised of roughly 50-70% water and drinking (or ingesting) roughly 2 liters of water per day. Droughts and agricultural salt incursion due to inadequate water management are often cited as significant causes for the failure of historic civilizations.
Anthropogenic water withdrawals in the United States are shown in Figure 13.1.1 in billions of gallons per day. Irrigation for agriculture and thermoelectric power are the two largest uses, and both of these uses have corresponding large wastewater runoffs. With public water supply at 50 billion gallons per day and a population of 300 million, per capita water use is roughly 50,000/300 = 170 gal/day (640 liters/day) which would include commercial uses, drinking water, fire fighting, washing, watering, etc. Note that Figure 13.1.1 does not include withdrawals for eco-system uses other than agricultural irrigation.
Water withdrawals are different from water consumption or use. Withdrawals for uses such as thermoelectric power are often returned directly to their source, although at a higher temperature. Similarly, public water supplies may be used, treated as wastewater, and returned to a river. Thus, water may be re-used and withdrawn numerous times.
Access to safe and sustainable drinking water and sanitary resources are major problems in many areas. The United Nations estimates one billion people lack access to safe drinking water and 3.5 billion people lacking access to sanitary facilities (WWAP, 2016). A Millennium Goal is to reduce the number of people without access to safe water in half by 2015.
Water transportation is a significant mode for freight traffic. Figure 13.1.2 shows inland waterway freight flows in the United States. The importance of the Mississippi water system and the Great Lakes are evident.
13.02: Duration and Extent of Water Infrastructure
Statistics and studies of water infrastructure typically make major distinctions among water supply, wastewater treatment, and other water infrastructure. We have combined all three in this module because particular infrastructure components may serve multiple purposes. For example, a particular dam may contribute to water storage, hydroelectric power generation, flood control, and recreational opportunities. Moreover, different water infrastructure elements all belong within the common general water cycle. For example, the output of a wastewater treatment plant will often be the input for a water supply system downstream. As recycling and reuse become more critical management strategies, an integrated strategy for water supply, wastewater treatment, and other uses becomes more important.
Unfortunately, summary statistics on the physical extent of the water infrastructure system are difficult to obtain. After all, the infrastructure has numerous owners and purposes. Some indication of magnitude is indicated in Table 13.1, showing the revenues and numbers of establishments for water supply, irrigation and sewage treatment in 2002 obtained from the US Economic Census. Figure 13.3 shows state and local spending alone on water and wastewater operations to be roughly \$ 20B each in 2001 dollars.
Table 13.2.1 - Summary Statistics for the Water, Sewage and Other Systems Sector from the 2002
2002 NAICS code
Kind of Business
Establishment (number)
Revenue (\$1,000)
2213
Water, sewage, and other systems..............................................................................
5 790
7 593 747
22131
Water supply and irrigation systems............................................................................
4 830
5 860 181
221310
Water supply and irrigation systems......................................................................... 4 830 5 860 181
22132
Sewage treatment facilities.........................................................................................
866
1 051 028
221320
Sewage treatment facilities...................................................................................... 866 1 051 028
22133
Stream and air-conditioning supply..............................................................................
84
682 538
221330
Stream and air-conditioning supply......................................................................... 84 682 538
Source: US Census, 2004, ‘2002 Economic Census’, Public Domain, www.census.gov/prod/ec02/ec0222i02.pdf
A typical water supply plant involves several process operations to filter and disinfect ‘raw’ water (Figure 13.2.2). Wastewater treatment has more variations, depending upon the design level of treatment (Figure 13.2.3).
Water infrastructure can be very long-lived, especially buried pipes, earthen structures and canals. Table 13.2.2 shows some estimated lives of water infrastructure components.
Table 13.2 - Estimated Useful Lives of Water Infrastructure Components
Source: US EPA, 2002, “Clean Water and Drinking Water Infrastructure Gap Analysis”, Public Domain, 901R0200, https://nepis.epa.gov | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/13%3A_Water_Infrastructure/13.01%3A_Introduction.txt |
Water infrastructure has a variety of government and private owners in nearly all geographic regions. In the US, city or regional public providers tend to be the most common arrangement. However, individual metropolitan areas may have multiple private and public water supply organizations. Municipal wastewater may be managed by a single entity, but industrial and residential wastewater treatment processes may also exist. For example, septic tanks may be used in outlying areas. Similarly, the US Army Corps of Engineers often has primary responsibility for flood damage mitigation, but numerous other entities may be involved. Navigation aids may be under the control of the US Coast Guard, but other agencies and private entities may also be involved.
Water quality standards play an important role in influencing infrastructure management. Most water standards are set at the national level, although standards exist for the European Union. Different standards may exist for drinking water quality, recreational water quality, and wastewater treatment outflows.
13.04: Some Infrastructure Management Issues for Water
Four overarching issues should be highlighted for water infrastructure management:
1. Achieving the United Nations’ Millennium goal (described above) of significantly increasing the availability of clean water throughout the world is a major challenge. Significant new investments and technology will be needed.
2. Dealing with water shortages in areas where demand exceeds sustainable supplies. Prioritizing water uses, seeking new sources and expanding re-use are possible strategies in these areas.
3. Pollution prevention and treatment continue to be major concerns. New pollutants such as hormones or bio-terrorism provide new challenges.
4. Replacing and improving existing water infrastructure is an issue in many parts of the world. In the ASCE, the water infrastructure receives a grade of barely passing (D) (ASCE, 2005) and components are continuing to age.
Financing investments for dealing with these challenges is proving to be difficult.
The US EPA believes that ‘better management practices, efficient water use, full-cost pricing of water and a watershed approach to protection can all help utilities to operate more sustainably now and in the long-term (EPA).
• Better Management of water and wastewater utilities can encompass practices like asset management and environmental management systems. Consolidation and public/private partnerships could also offer utilities significant savings.
• Rates that reflect the Full Cost Pricing of service and rate restructuring can help utilities capture the actual costs of operating water systems, raise revenues, and also help to conserve water.
• Efficient Water Use is critical, particularly in those parts of the country that are undergoing water shortages. We need to create market incentives to encourage more efficient use of water and to protect our sources of water.
• Watershed Approaches looks more broadly at water resources in a coordinated way, which is challenging because we have not traditionally thought of infrastructure management within the context of water quality protection.
13.05: Chapter 13 Exercises
13.1 (5 pts)
Where does your local drinking water come from? How might you identify its quality relative to clean water standards?
13.2 (10 pts)
How much does drinking water cost (in \$/liter) is your locality from (a) the regular tap or (b) the nearest source of retail bottled water.
13.3 (10 pts)
Based on the typical local rainfall and water use in your area (e.g. city or metropolitan area), how much land is required as a watershed?
13.06: Chapter 13 References
references | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/13%3A_Water_Infrastructure/13.03%3A_Institutional_Arrangements_for_Water_Infrastructure.txt |
Telecommunications assist information exchange over a distance by means of transmitters, a transmission medium and receivers. A variety of transmission media have been used over time, such as the electric connection used in telegraphy or fiber optic cables for the Internet. Digital messages are becoming the norm for telecommunications, with analog signals such as speech translated to digital signals for transmission. A variety of protocols exists for interpreting messages on different media.
Figure 14.1.1 shows the growth over a fifteen-year period in various aspects of telecommunications, focusing on telecom and internet service. The rapid growth in Internet users and in mobile cellular subscribers is particularly notable.
Figure 14.1.2 shows the growth over time of a segment of telecommunications, namely international calls from or to the United States. The amount of traffic has increased substantially, while the price per minute has declined by an order of magnitude from 2000 to 2014.
Telecommunications are dominated in the United States by private corporations (FCC 1996). Overseas, examples of both private and public providers exist. The ownership structure for telecommunications infrastructure is complex, with building owners responsible for their own internal telecommunications and companies often sharing facilities such as cell towers or neighborhood telephone poles.
14.02: Duration and Extent of Tele-communications Infrastructure
Figure 14.1.1 showed the rapid growth in the number of users of telecommunications services. In addition, new applications require large amounts of information to be available rapidly. Figure 14.2.1 shows some of the demands for applications such as videoconferencing and entertainment (such as movies on demand).
A variety of media are used for telecommunications, including copper wires, fiber optic cables and wireless transmission. Even power wires can be used for communication. As an indication of the extent of this infrastructure, Figure 14.2.2 shows a map of submarine communications cable as of 2015. In addition to these undersea cables, roughly 1,000 communications satellites are in orbit around the earth. Internet services also make use of high speed, high capacity connections such as fiber optic cables and satellite communications.
The duration and extent of telecommunications infrastructure depend in large part on how the infrastructure is defined. For example, radio and television transmission towers are often classified as entertainment rather than telecommunications (and are omitted from the statistics shown in Figure 14.1.1). Nevertheless, radio and television now may be broadcast or provided over the Internet.
Wireless communications, particularly with mobile telephones and personal digital assistants (PDAs) have also seen notable growth Clarke, 2014). These services typically connect through cell sites to the regular telecommunications network; with some 300,000 such cell sites existing in the US in 2012 (See Figure 14.2.3).
With rapid expansion of use and growing speed and capacity, many parts of the telecommunications infrastructure have relatively short lifetimes. Smartphones and computers may become functionally obsolete within five years. In contrast, some parts of the infrastructure may have relatively long lifetimes. Fiber optics
Interdependence between telecommunications and other infrastructure systems is apparent. For example, telecommunications is needed to manage the electric power grid, while electricity is needed for telecommunications. Back-up power by means such as batteries is provided to ensure continuing telephone service in case of power interruptions.
The growth of the internet has increased the complexity of the telecommunications network and the extent of infrastructure interdependencies. As an illustration, Figure 14.2.4 shows a partial map of the internet, where nodes are internet protocol (IP) addresses and the length of links shows the typical delay between two IP addresses.
14.03: Organization of Telecommunications
The bulk of telecommunications is in private ownership, although there are notable examples of public, non-profit owners and government owners of such infrastructure.
As an example, the Internet has multiple companies providing services. Individual companies or individuals may maintain local area networks which are connected to Internet Service Providers (ISPs). In turn, the ISPs connect to backbone service providers. In effect, the Internet is a network of networks with routers handling packets of information. Protocols and management guidance is provided by organizations such as the Internet Society.
Regulation of telecommunications is also distributed. In the US, the Federal Communications Commission (FCC) was established by the Communications Act of 1934 and is charged with regulating interstate and international communications by radio, television, wire, satellite and cable.
Allocation of the electromagnetic radio spectrum is a major activity in telecommunications regulation. In essence, users do not want interference in using allocated parts of the spectrum. Broadcast radio stations were among the first to have allocated frequencies which were managed to prevent signal interference. As illustrated by the 2016 United States frequency allocation chart in Figure 14.3.1, a very large number of spectrum users must now be accommodated.
14.04: Some Infrastructure Management Issues for Tele-communications
Tele-communications has similar management problems as other infrastructure systems, such as power generation or roadways. Numerous structural elements such as cables, satellites, towers and relay stations must be inspected, maintained and replaced over time. Communications traffic must be managed, including dealing with congestion.
Pricing of services and financing necessary infrastructure is a complex issue for telecommunications, particularly as multiple companies may be involved in handling communications. With the merging of Internet, telephone and entertainment, additional complications in pricing services (and illegal copying) arise.
14.05: Chapter 14 Exercises
P14.1 (5 pts)
How are the prices charged for mobile telephone service related to the cost of providing services?
P14.2 (5 pts)
How many cell sites can you identify within 1 km of your residence?
14.06: Chapter 14 References
References
• Clarke, Richard N. "Expanding mobile wireless capacity: The challenges presented by technology and economics." Telecommunications Policy 38.8 (2014): 693-708.
• Federal Communications Commission. "Telecommunications Act of 1996." Public law 104.104 (1996): 1-5. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/14%3A_Telecommunications_Infrastructure/14.01%3A_Introduction.txt |
‘Electrification’ was selected by the US National Academy of Engineering as the greatest engineering achievement of the twentieth century (NAE 2008). Electricity is a primary power source throughout the developed world and many other infrastructure systems depend upon electricity such as buildings and telecommunications.
Figure 15.1.1 shows the historical sources of energy consumption in the United States. Until the twentieth century, wood was a predominant source of energy, with the early twentieth century seeing the growth in coal use. By 1920, petroleum and national gas became large sources of energy. Nuclear power began in 1950 with the development of the atomic industry.
The electricity system was created in the late nineteenth century in the United States for the primary purpose of lighting. Thomas Edison built and promoted a direct current network, while George Westinghouse proposed an alternating current network. In 1881, electricity rates were \$ 0.24/kWh (equivalent to roughly \$ 5/kWhr in current dollars), while modern electricity rates are around \$ 0.10/kWh. Alternating current power grids have become the norm for reasons of efficiency throughout the world, although local direct current wiring can be used for light-emitting diode (LED) lighting and electronics.
US electricity energy flows for 2007 are shown in Figure 15.1.2. Coal, natural gas and nuclear power are the predominant primary energy sources, with renewable energy – including hydroelectric and wind power- fourth in magnitude. Other sources are relatively minor. Conversion losses of primary energy sources to electricity are substantial; moreover, this graphic does not include energy costs of mining, refining and transporting the primary energy sources to power generation sites. Predominant electricity uses are classified by EIA as residential, commercial or industrial.
World primary energy sources for electricity are similar to the US, with coal, natural gas, renewable sources and nuclear energy the primary sources (Figure 15.1.3), although hydroelectric is larger for the world than for the US itself. However, this distribution can vary substantially from region to region. Some countries have developed extensive and inexpensive geo-electric and hydro-electric power generation (such as Iceland), while others emphasize nuclear power generation (such as France.) Qatar is an example of a country dependent upon natural gas and oil sources.
Electricity is an intermediate carrier of energy, with a variety of underlying sources. Figure 15.1.4 illustrates overall US energy use and sources, with petroleum used primarily for transportation and heating.
15.02: Duration and Extent of Electricity Infrastructure
The electricity infrastructure includes generators (power plants), transmission lines, substations, distribution lines, transformers, control devices and users (Figure 15.2.1). There is also supply chain infrastructure required for electricity supply, such as the mining and transportation of coal to power plants for combustion.
Table 15.2.1 indicates the 2015 numbers and capacity of electricity generators in the US. The average generator has a rated capacity of 1,167,365MW/20,068 generators = 58 MW. Generation plants themselves can have long lives, with dams and power plant structures lasting for many decades. Operating equipment such as turbines have much shorter useful lives and must be replaced regularly in power plants. There is a trend for increasing reliance on natural gas and other renewable sources of energy and less reliance on coal due to environmental concerns and the relative prices of different sources.
Table 15.2.1: Summary of Power Generation Statistics
Fuel Source Generators Nameplate Capacity (MW) Summer Capacity (MW) Winter Capacity (MW)
Coal 968.00 304,789.80 279,719.90 281,105.80
Hydroelectric 4,176.00 100,529.60 102,239.30 101,535.20
Natural Gas 5,717.00 503,822.70 439,320.80 472,388.40
Nuclear 99.00 103,860.40 98,672.00 101,001.40
Other 407.00 8,557.50 6,585.30 6,859.70
Other Gas 1,778.00 5,154.70 4,681.90 4,710.20
Other Renewable 623.00 11,177.70 9,768.30 9,877.40
Petroleum 3,550.00 42,321.30 36,830.30 40,372.60
Solar 1,652.00 13,758.30 13,663.30 13,427.00
Wind 1,098.00 73,393.20 72,573.40 72,675.80
Grand Total 20,068.00 1,167,365.20 1,064,054.50 1,103,953.50
Source: US Energy Information Administration, Form EIA-860, 2016. Public Domain. www.eia.gov/electricity/data/eia860/
Generated power from turbines is normally transmitted as 3-phase alternating current. As a result, transmission lines usually provide three separate wires, one for each phase. Transmission lines are quite extensive throughout the United States, although congestion in some portions of the network is increasing. The US is divided into three major power grids (Figure 15.2.2), plus separate grids for Alaska, Hawaii,and other territories. As of 2015, the US bulk electric distribution system consists of more than 360,000 miles of transmission lines including 180,000 miles of high-voltage AC transmission (Energy, 2015).
Electric power distribution across the contiguous United States occurs through the operations of some 500 individual companies. Figure 15.2.3 below illustrates pre-2008 transmission grid voltage and density.
From the transmission lines, substations typically step-down the voltage for distribution to end-users (Figure 15.2.4). Large users such as industries or military bases might have their own substations.
Distribution to customers involves transformations to reduce voltage (to a common level of 240 or 120 V) and to provide single-phase alternating current. Tele-communications and electricity service generally share the same telephone poles or underground pipes. For safety reasons, electricity service occupies the highest portion of the common telephone pole (Figure 15.2.5). Local transformers reduce voltage to residential service levels. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/15%3A_Electricity_Power_Generation_Transmission_and_Distribution_Infrastructure/15.01%3A_Introduction.txt |
In the early years of electricity use in the US, electric utilities were private, small and vertically integrated. Over time, all of these characteristics have changed. Public operating companies emerged, such as the various rural co-operatives and the federal Tennessee Valley Authority. Economies of scale led to much larger companies, with Pacific Gas & Electric having over 5 million customers. Finally, organizations can now specialize in one system aspect, such as power generation, transmission or distribution.
Grid management is provided by regional transmission organizations (RTO), such as PJM in the Pittsburgh region. These organizations provide a market for wholesale energy purchases, matching demands for power and supply from power generators. Electricity demand varies over the course of a day (with low points in the middle of the night) and over the course of a year (with heavy air conditioning electricity demands in the summer). Electricity supply can also vary as plants come on and offline or as wind turbines and solar panels respond to weather conditions. As a result, balancing demand and supply is sometimes difficult, especially since storage of generated power is expensive. In practice, the RTO must keep extra, rapid response generating capacity available for demand or supply fluctuations. Moreover, the marginal cost of providing electricity varies over time, including relatively short units of time.
The US regulatory regime for electricity is complicated and changing over time. At the federal level, the Federal Energy Regulatory Agency (FERC) is a key player, with authority to regulate inter-state electricity sales, wholesale electricity rates and hydroelectric power. FERC has issued reliability standards for electricity provision. At the state level, Public Utility Commissions provide varying levels of regulation.
15.04: Some Infrastructure Management Issues for Electricity
The relative costs of different generating modes vary considerably from year-to-year, day-to-day and even minute-to-minute. Solar and wind power are intermittent and subject to rapid stoppages. The prices of coal, natural gas and petroleum can vary considerably. The cost of nuclear power plant construction and uranium fuel also have great uncertainty. Tax credit provisions for renewable energy also exist, at both the federal and state levels, and these often change over time. As a result, risk management and cost minimization are continuing challenges.
A few power interruptions per year are fairly common but can have substantial costs for users (Figure 15.4.1). Worker productivity declines and refrigerated items may end up spoiling. Establishments with urgent needs for continuous power such as hospitals may invest in back-up generator systems.
Electricity generation is responsible for the largest sector share of greenhouse gas emissions in the US inventory (See Better Management EPA inventory reports at: http://www.epa.gov/climatechange/emi...oryreport.html) As a result, there are continuing proposals for regulation or tax on power generation emissions. Conventional air emissions are already regulated, such as the cap-and-trade regulation on Sulphur dioxide emissions.
Renewable energy goals and standards are becoming common in the US, motivated by environmental concerns, energy independence and hopes that investment in new forms of energy will spur innovation and scale economies that reduce costs. For example, the renewable portfolio standard enacted by Governor Edward Rendell in 2004 as the Alternative Energy Portfolio Standards Actn213 in Pennsylvania has provisions requiring that qualified power sources provide 18.5 percent of Pennsylvania’s electricity by 2020. There are two tiers of qualified sources that meet the standard. Tier 1 sources must make up 8 percent of the portfolio, and include wind, solar, coal mine methane, small hydropower, geothermal, and biomass. Solar sources must provide 0.5 percent of generation by 2020. Tier 2 sources make up the remaining 10 percent of the portfolio, and include waste coal, demand side management, large hydropower, municipal solid waste, and coal integrated gasification combined cycle (PA213, 2004).
With greater reliance on renewable energy sources, management of the grid becomes more difficult, with the need for robust back-up power or real-time demand management. Interruptible power contracts already exist, and there is considerable interest in improved demand-side management and real-time pricing. Moreover, the location of generating sources changes, with concomitant need for new investment in transmission infrastructure.
A variety of risks also exist for power generation infrastructure. As identified by the Department of Homeland Security (2015), the major risks to the US infrastructure are:
• Cyber and physical security threats;
• Natural disasters and extreme weather conditions;
• Workforce capability (“aging workforce”) and human errors;
• Equipment failure and aging infrastructure;
• Evolving environmental, economic, and reliability regulatory requirements; and
• Changes in the technical and operational environment, including changes in fuel supply.
Cybersecurity and natural disasters have received considerable attention from power generation infrastructure managers, but much more effort is needed to ensure resilient and secure infrastructure.
15.05: Chapter 15 Exercises
P15.1 (5 pts)
How could residences take advantage of real-time electricity pricing?
P15.2 (5 pts)
Small scale co-generation of heat and power for buildings is available from fuel cells. What are the grid implications for this effect?
P15.3 (5 pts)
Several automobile companies are planning plug-in hybrid vehicles. What are the implications for electricity provision? What are the management issues to be addressed?
15.06: Chapter 15 References
References | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/15%3A_Electricity_Power_Generation_Transmission_and_Distribution_Infrastructure/15.03%3A_Institutional_Arrangements_for_Electricity_Infrastructu.txt |
In the past few chapters, specific types of infrastructure systems have been discussed. Infrastructure such as roadways and power generation is widespread and of great social importance. Organizations exist for the management of this infrastructure. While managers must consider inter-action and inter-dependency among different types of infrastructure, the institutional control over different infrastructure systems are typically independent.
Military bases, campuses, parks and ports are different with regard to institutional arrangements for infrastructure. Typically, a single organization is responsible for managing all of the infrastructure for these entities. Moreover, these integrated entities are generally sufficiently large to warrant employment of a professional staff of infrastructure managers. As a result, many professional infrastructure managers work in these integrated entities.
These facilities are also unusual in the types of infrastructure that may be included. Military bases have specialized infrastructure for their specific missions, such as ordnance storage facilities. Industrial and university campuses often have specialized laboratory equipment and facilities. Parks have historic buildings and priceless natural features. Ports have specialized equipment for handling freight and passengers. Even golf courses (considered here a form of parks) have special requirements for landscaping.
Figure 16.1.1 illustrates a former military base (Fort Jefferson) now located in a national park (Dry Tortugas) on an island remote from the mainland. This is a complicated facility, with historic structures for the fort and modern infrastructure to generate power, water supplies, wastewater and telecommunications. A small port is also on the island for both boats and seaplanes. As a national park, preservation of the natural eco-systems is a priority. Managing the infrastructure on this island is a complicated job for the National Park Service!
Figure 16.1.2 illustrates a university campus, which is another example of a single institution with multiple infrastructure systems. A university campus can rely on external infrastructures such as power generation and transportation services. But a multitude of services are provided on campus, including internal transportation circulation and parking, water and power distribution, and buildings.
Ports are another example of single-institution entities with a significant amount of infrastructure and specialized facilities. Airports, seaports, and inland waterways (as illustrated in Figure 16.1.3) are all examples of such entities.
16.02: Extent and Duration of Base Campus Park and Port Infrastructure
Bases, campuses, parks, and ports are widespread. Figure 16.2.1 illustrates the numbers of global airports; the numbers of military bases, campuses, parks, and seaports would be just as large. Figure 16.2.2 shows the freight tonnage of imports, exports and domestic cargo at large US seaports in 2006. As can be seen, inland waterway ports (such as Huntington or Pittsburgh) handle significant amounts of freight. All countries have bases, campuses, parks, and ports, and expansions such as designating new parks are common.
The duration of these entities is also quite lengthy, with university campuses, parks and ports lasting longer than institutions such as corporations. Military bases can be long-lasting, although new technology can make some bases obsolete (such as Fort Jefferson in Figure 16.1). Similarly, seaport facilities must be periodically altered due to new technology such as freight containerization or larger vessels.
Because these integrated entities are long-lasting, infrastructure managers can often adopt a long planning horizon in making investment decisions. For example, buildings on university campuses can be rehabilitated regularly but the basic structures and layouts can last for decades (if not centuries). However, technological developments often suggest regular change in infrastructure for functions such as computing or communications.
All types of infrastructure can be found at these integrated entities, including roadways, buildings, power generation, telecommunication and power generation. In addition, specialized infrastructure such as airport runways and docking facilities exist.
Another feature of these integrated entities is the concept of ‘deferred maintenance.’ Since integrated entities are long-lived, recommended maintenance or rehabilitation can be deferred, resulting in lower infrastructure quality and functionality but corresponding with budget limitations. Deferred maintenance can and often does increase from year to year.
16.03: Institutional Arrangements for Bases Campuses Parks and Ports
The institutional managers of bases, campuses, parks, and ports vary considerably among different entities and nations. Some typical arrangements are:
• Military bases are usually controlled by particular branches of the military service, such as Army, Air Force, Coast Guard, Marines or Navy.
• Campuses may be controlled by government agencies (as with the Department of Energy Laboratories), corporations, or non-profit entities (such as Dartmouth College shown in Figure 16.1.2).
• Parks may be controlled by national, state or local government agencies. Privately owned parks also exist, such as the Disney Corporation resorts.
• Ports may be controlled by corporations, government agencies or other non-profit entities.
The concepts associated with infrastructure management outlined in the first ten chapters of this book, and illustrated in Figure 16.3.1 below, apply both to independently controlled and integrated entities. Campus infrastructure managers regularly perform asset management, inventory, benchmarking, etc.
However, some regulatory differences exist for integrated entities. For example, campuses, parks and ports typically have master planning processes in place for long-term infrastructure changes. These plans may include elements such as locations and rough shapes for future buildings and designations of permanent open space. New infrastructure is explicitly tied to the entities overall mission (e.g., education and research for universities), and all new buildings or other investments would then be designed to conform to the master plan. Cities and states have similar master planning processes, but these typically recognize the dispersed decision making associated with dispersed ownership of infrastructure.
Transitions in institutional arrangements for these integrated entities can also occur, although usually over a lengthy period of time. For example, Figure 16.1.1 showed Fort Jefferson which was transferred from military control to the National Park Service. Private community and resort developers may control the entire property initially, but then control is transferred to individual property buyers and eventually a community governing organization.
16.04: Issues in Infrastructure Management for Bases Campuses Parks and Ports
Integrated entities have some opportunities for synergies among infrastructure systems that may be difficult to achieve in more dispersed organizational settings. Adopting a long term management view can also provide advantages.
One example of such synergies is the use of ‘utilidors,’ or underground tunnels with multiple utilities for water, power, telecommunications and transport. Figure 16.4.1 illustrates a large utilidor used at a Disney resort. Figure 16.4.2 shows a smaller utilidor used for underground utilities at a university campus. Utilidors simplify maintenance of underground utilities, avoid overhead utility connections and permits easier upgrades for systems such as telecommunications. They require an initial capital investment for construction, but then lower costs over time.
Another example of potential synergies is the adoption of combined heat and power (CHP) systems. These systems generate electricity but also use the waste heat productively. An isolated power plant may not have the opportunity to use the waste heat effectively and often must use significant amounts of water for cooling.
Another source of potential advantages for integrated entities is the effect of scale economies on costs. For example, purchasing large amounts of supplies can result in cost savings. Similarly, integrated entities may be able to better control demands and scale infrastructure to the best sizes possible.
Not all integrated entities are compact, however. Parks may have multiple facilities spread over a large area. In these cases, managers may have to make special efforts to provide essentials such as power, water and wastewater treatment to isolated campgrounds or buildings. Figure 16.4.4 shows a typical isolated service structure of this type.
Because of the scale of integrated entities, they can have significant environmental and social impacts. As a result, their infrastructure managers should endeavor to minimize their impacts. For example, integrated entities have been leaders in adopting green design standards (Committee, 2013).
16.05: Chapter 16 Exercises
P16.1 (5 pts)
Considering figure 16.6, describe how these generic asset management processes might differ between an integrated entity (university, military base, etc.) and a municipality.
16.06: Chapter 16 References
References
• Committee to Evaluate Energy-Efficiency and Sustainability Standards Used by the Department of Defense for Military Construction and Repair (2013), ‘Energy Efficiency Standards and Green building Certification Systems Used by the Department of Defense for Military Construction and Major Renovations,’ National Academies Press. | textbooks/biz/Management/Fundamentals_of_Infrastructure_Management_(Coffelt_and_Hendrickson)/16%3A_Bases_Campuses_Parks_and_Port_Infrastructure/16.01%3A_Introduction.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Define the difference between a nonprofit organization and other types of organizations.
• Understand the different terminology associated with the nonprofit sector.
• Start to understand the scope of the nonprofit sector in the United States.
What are nonprofit organizations?
Whether you know it or not, nonprofit organizations are ubiquitous in American society. They are part of almost everyone’s lives every day. Nonprofit organizations can be small, such as local social or activity groups like soccer clubs or homeowner’s associations covering a single neighborhood. They can also be larger, such as state advocacy organizations working in the capitol to change policy or international humanitarian organizations with thousands of members and budgets in the billions. They provide human services and offer opportunities to enjoy art and culture. They raise money for community needs and also distribute billions of dollars to other nonprofit organizations.
But the question remains – what are they? How are they defined? And how might they be different from other organizations, including for-profit businesses or public sector agencies?
The nonprofit sector includes private, voluntary, “not-for-profit” organizations, along with other voluntary associations.[1] They can be either formally registered with the IRS as a tax-exempt corporation or informal gatherings of individuals. In fact, in 2019 there were approximately 1.5 million formally registered nonprofit organizations in the United States, with an estimated additional 1 million unregistered groups.
One thing that almost all nonprofits share, however, is that they are tax-exempt, meaning they are not required to pay many forms of tax, particularly taxes on contributions and grants.[2] In addition, they have what is called a non-distribution constraint; they are not allowed to distribute profits to the managers or “owners” of the organization.[3] This is an important distinction from for-profit businesses, especially because nonprofits don’t have “owners” in the traditional sense we may think of. While the managers and volunteer board of directors in a nonprofit organization are responsible for protecting the organization’s reputation and resources, they don’t “own” the organization. Instead, nonprofit organizations are incorporated by states and the federal government and are, in effect, owned by the taxpayers.
In exchange for a tax-exemption benefit, nonprofit organizations are expected to work towards the public good in some way. That term can be broadly applied and may include providing much needed services to offering opportunities for people with shared goals and values to come together. In this way, nonprofit organizations are mission driven, not profit-driven.
Nonprofit organizations typically have the following features:
• Not profit-seeking.
• Non-distribution constraint.
• Organized outside of government and business.
• Self-governing and independent.
• Formally constituted (legal filings, bylaws, etc.).
• Voluntary.
As mentioned earlier, many groups of individuals may look and act like a nonprofit organization but are not formally constituted as tax-exempt corporations under the law. Also, although it is true that you generally can’t be compelled to join or participate in a nonprofit organization, there are some situations in which you may be called on to join a nonprofit in order to participate in a certain profession (such as a labor union or the American Bar Association for attorneys) or to live in a specific neighborhood (homeowner’s associations).
What types of organizations are there?
There are many different types of nonprofit organizations in the United States and around the world. The National Taxonomy of Exempt Entities (NTEE) is one way that the IRS and other researchers classify nonprofit organizations. When an organization files the application to become a tax-exempt corporation, the IRS uses the organization’s stated mission statement to identify their NTEE classification. Major NTEE categories include:
• Arts, Culture, and Humanities.
• Education.
• Environment and Animals.
• Health.
• Human Services.
• International, Foreign Affairs.
• Public, Societal Benefit.
• Religion Related.
• Mutual/Membership Benefit.
• Unknown, Unclassified.
Under this primary classification, there are a series of sub-classifications to help identify a nonprofit further, such as codes for advocacy organizations, higher education, professional societies and associations and those that provide monetary support to others, just to name a few. The IRS also separates organizations under different sections of code.
There are many different names used to describe the nonprofit sector. While these names are often used interchangeably in scholarship and practice, there are subtle differences in their meanings.[4]
• Charitable organizations are groups whose work is primarily seen as “helping the needy.” While some nonprofit organizations “help the needy,” there are also many organizations that engage in other types of activities, including social and religious organizations and political and advocacy organizations.
• Independent Sector emphasizes that the role of the nonprofit sector is outside of both government and the business sector, as it is autonomous from the other two sectors in making decisions and engaging in activities. Yet, there are many nonprofits that engage in commercial activities or are closely partnered with government through contracts and grants.
• Nongovernmental organizations (NGO) is the term used primarily outside of the United States for the nonprofit sector. There are local NGOS as well as international NGOs that work across borders (INGOs).
• Voluntary organizations are those that depend on gifts of money or time to run their programs and activities. Many smaller and community organizations can be considered voluntary organizations; however, this tends to omit larger organizations with paid staff and those that are funded largely through government.
• Social Sector describes the group of organizations that work on behalf of social aims and goals, but this term does not require an organization to be nonprofit.
Peter Frumkin[5] describes two different types of nonprofit organizations: instrumental and expressive. Instrumental organizations work as an “instrument” to engage in an activity or to get something done, such as providing medical services, running a food bank or providing childcare. In this way, they have tangible outputs that can be measured. Expressive organizations, on the other hand, help bring people with shared values and beliefs together. These could be religious organizations or social or political groups. Instead of seeing a dichotomy of instrumental OR expressive, it’s probably better to view these categories as two ends of a long-spectrum.
The American Red Cross (ARC) was founded in 1881 by Civil War nurse Clara Barton to “prevent and alleviate human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors.” Since its founding, ARC has responded to an untold number of disasters, including responding to house fires; setting up shelters and providing food to areas hit by hurricanes, earthquakes or fire; training people in first aid and CPR and helping to collect and manage blood for those who need it. Although they have about 35,000 paid staff members across the country and around the world, the activities of the Red Cross are supported by over 300,000 volunteers. Volunteers can turn their “compassion into action” by supporting people in their own communities and often volunteer for the Red Cross for decades, finding great meaning and satisfaction in their service.
• Do you think the American Red Cross is an instrumental or expressive organization? Or both? Why or why not?
• Think of other nonprofit organizations in your community. Would you consider them expressive or instrumental?
One way to think about nonprofit organizations is that they have features that are similar to, and distinct from, the for-profit business sector and government sector.[6] The below table demonstrates where nonprofit organizations are more similar to businesses and where they are more similar to government.
More Like Business More Like Government
Privately Controlled X
Non-distribution Constraint X
Incorporated X
Tax-Exempt X
Lines of Accountability X
Can’t Compel you to Pay (i.e. taxes) X
Money Raised Elsewhere for Services/Activities X
Ethical Obligations to Public X
Further defining nonprofits
While there is a wide range of types of issues nonprofit organizations work on (such as education, environment or health care as discussed above), there are just as many different roles nonprofit organizations can take based on their mission and goals.
Helmut Anheier[7] describes one way to think about these roles: categorizing organizations based on who they serve. The first group, member-serving organizations, are those organizations whose mission and purpose is to provide some sort of benefit or representation for their members. Many associations fall into this category, including professional associations and homeowner’s associations. Social, sports and religious organizations may also fall under this category.
Public-serving organizations, on the other hand, are those groups who have a public goods or public benefit focus, focusing on clients, beneficiaries or public at large. Health, education and environmental organizations may fall into this group. So too can organizations serving the unhoused or helping people overcome food insecurity.
It is also possible to describe organizations as market or non-market organizations. Market-based organizations are those that generate revenue by providing goods or services through commercial activities – sometimes called fee for service. Examples of these organizations are institutions of higher education – which charge tuition – and hospitals. There are a lot of other human-service related organizations that charge, at least marginally, for their services. Market organizations may also include social enterprises (covered in Chapter 8), which use the market to create social value.
Non-market organizations, on the other hand, are those that generally receive revenue either from private sources (individual donations, grants from private foundations) or from public sources (government contracts, government grants).
Summary and Activities
• Nonprofit organizations play a significant role in the American economy and social fabric.
• They are extremely diverse in both form and function – ranging across mission/issue areas and types of activities they do.
Activity 2
1. In small groups, look up the following two organizations working to support affordable housing opportunities in Eugene, OR. Can you tell if they are for-profit, nonprofit or public?
2. Look up the U.S. Chamber of Commerce, National Public Radio and The Smithsonian Institution online and review their missions. Would you consider them member-serving or public-serving organizations? Why or why not?
3. Review the websites for Doctors Without Borders and World Vision. Do you consider them instrumental or expressive organizations? Why or why not?
1. Helmut K. Anheier, Nonprofit Organizations: Theory, Management, Policy, 2nd ed. (New York: Routledge, 2014), http://books.google.com/books?hl=en&...fnd&pg=PP1&dq="edition published in the Taylor and Francis e-Library," "purchase your own copy of this or any of Taylor & Francis or" "2005 Helmut K." "known or hereafter invented, including photocopying and" &ots=XwI7vdB88A&sig=SK_snvwMXOI0aEPXu2Kj0Q3O73U.
2. Kelly LeRoux and Mary K Feeney, Nonprofit Organizations an Civil Society in the United States (New York: Routeledge, 2015).
3. Henry B. Hansmann, “Economic Theories of Nonprofit Organizations,” in The Non-Profit Sector: A Research Handbook, ed. Walter W. Powell (New Haven, CT: Yale University Press, 1987).
4. LeRoux and Feeney, Nonprofit Organizations an Civil Society in the United States; Anheier, Nonprofit Organizations.
5. Peter Frumkin, On Being Nonprofit: A Conceptual And Policy Primer (Cambridge, MA: Harvard University Press, 2005).
6. Frumkin.
7. Anheier, Nonprofit Organizations. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.01%3A_Introduction.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Understand why the nonprofit sector is seen to exist.
• Define and understand the main theories applicable to the nonprofit sector.
• Consider why nonprofit organizations and their roles vary around the world.
Chapter Introduction
As discussed in the previous chapter, the nonprofit sector in the United States is incredibly large, with over 1.5 million registered organizations and another estimated 1 million informal groups. How did this come to be? Why does the nonprofit sector look the way that it does? And, perhaps more significantly, why does the nonprofit sector exist in the first place?
Over the last fifty years, nonprofit scholars have been developing theories that describe, define and shape the nonprofit sector, as well as explain its roles, responsibilities and behaviors. This chapter will present the main theories of the nonprofit sector and relate them to actual organizations.
The “Four Failures”
Compared to for-profit businesses or government agencies, nonprofit organizations have their own strengths and weaknesses. Nonprofits are distinct organizational forms that are seen to exist for many reasons, with the leading theories sometimes described as the “Four Failures”:
• Market Failure.
• Government Failure.
• Contract Failure.
• Voluntary Failure.
Market Failure
Market Failure is a broad term often used in economics, political science, public administration and nonprofit studies. It defines a situation in which the market (business sector) fails to produce demanded goods and services. This failure leads to an inefficient distribution of goods and services by the “free market.” Richard Steinberg [1] argues that businesses may: fail to produce goods or provide services demanded by the public; over-restrict access to certain goods (such as by pricing too high); or fail to meet consumer expectations around the quantity or quality of the good/service.
In the case of the nonprofit sector, market failure is particularly relevant when goods or services for critical needs – such as health care, education, food or job training – aren’t available to those that can’t afford “market prices.”
While it may seem that market failure happens simply because businesses can’t “make a profit,” there are other reasons the market may fail. Different types[2] of market failure include:
• Information asymmetries, which occur when the parties to any transaction have different levels of information about the quality of the product/service. This can lead to exploitation, such as when someone selling a car knows there is a significant issue with the engine and fails to provide this information while encouraging you to buy it. Government often intervenes to prevent information asymmetries through regulations that protect consumers, such as requiring certain disclosures by the seller or by establishing “lemon laws.”
• Externalities, also called “spillover effects,” which occur when benefits (positive) or costs (negative) impact someone who is not directly involved in a transaction. For example, a firm exposes the community to pollution while making its product. Government may also intervene in these cases through regulation (such as regulating or fining polluters), but nonprofit organizations may also get involved by holding organizations accountable to the law, either through political pressure or through litigation.
Activity 1
An Oregon based nonprofit, Beyond Toxics works to limit the impact of pesticides and other toxins in communities across the state. They recognize the role of pollution on communities, and their climate justice initiative recognizes that “Frontline communities historically and presently bear the brunt of health, economic and ecological impacts that are the consequences of climate change.” They engage in advocacy and education efforts to reduce pollution and protect communities from harm.
Review the Beyond Toxics website.
• What type of externalities do they try to prevent or reduce?
• How does the organization link the externalities of pollution to the ideas of climate justice?
• What IS climate justice?
• Free-Rider problem, where individuals will not participate in the provision of (pay for) a good or service unless they are compelled to do so. This is especially the case when they can receive the good without having to pay for it (for example, driving down a road, enjoying a park or listening to public radio).[3] Government intervenes in this case by compelling people to pay for the good or service through taxation. These types of goods are called non-excludable public goods and make up many of the goods and services government and nonprofit organizations provide. However, students know about the free-rider problem personally when they are working on a team project and one group member chooses not to contribute but expects to receive the same grade!
• Monopolies, where the market is concentrated on one provider, often allowing the provider to charge whatever they would like for a product. Monopolies can be particularly problematic if they are providing goods or services that are needed by the public, such as medical care or electricity. Government often regulates monopolies by placing a cap on what they can charge, or may even break them up into smaller organizations.
Traditionally, market failures are one of the main reasons government intervenes with taxes and regulations. If people won’t voluntarily provide funds for a public good (free-rider problem), government will tax the public in order to provide them, such as collecting taxes to fill potholes in the road or build a new bridge. If buying a car is risky because you don’t know about the maintenance history (information asymmetries), states might pass a “lemon law” to protect your rights in the event the car breaks down shortly after purchase, allowing you a full refund. Government may fine polluters for dumping into a local river (externalities). Government may also set price caps for public goods provided by a monopoly, such as a public utility.
Government Failure
Yet, sometimes government failure also impacts the availability of public goods and services. Government failure may exist because government is unwilling or unable to provide that public good or service. One theory to explain government failure asserts government is only interested in producing goods that are desired by the majority of the public (also called the median voter theorem).[4] This leaves some goods and services under-provided by both market and government.[5] In the nonprofit context, this might include goods and services as diverse as arts organizations or mental health services. More broadly, it could include advocacy organizations working to protect public goods like forests, parks, clean air and public waterways.
In both market and government failure, the public cannot access goods and services. This is where nonprofits step in, “filling the gaps” left behind by the inability of government and the market to provide for the public.[6]
Activity 2
Explore the websites for the below organizations. Do you think they are responding to market failure? Government failure? Why or why not?
Image: Getty Images/Stock Photo
Contract Failure
Contract Failure, on the other hand, is a distinct form of market failure that relates to information asymmetries. The public recognizes that a nonprofit organization is mission driven, not profit driven, and therefore may expect a better service than one provided by a for-profit business or government agency.[7] In this case, the public is more willing to select a nonprofit provider over other types of organizations because nonprofits are considered more trustworthy by the public.
Voluntary Failure
The last of the “four failures” is called Voluntary Failure. That is, no matter how much money is donated, or time given by volunteers, the nonprofit sector is insufficient to solve problems on its own. This failure requires that the public sector (government) shore up the nonprofit sector through financial support. Lester Salamon[8] considers four reasons for voluntary failure:
Philanthropic Insufficiency: Simply put, the nonprofit sector is not, on its own, able to generate or organize the resources necessary to “get to scale” and be large enough to solve society’s problems. This is partially due to the free-rider problem, but also relates to how private donations are simply not adequate to provide for all desired public goods and services.
Philanthropic Particularism: This is the criticism that nonprofit organizations select only sub-groups to serve rather than the wider public. For example, groups may only serve individuals of a particular religion or ethnic group, or may serve only the people in a particular neighborhood, or their specific interests or profession. This can lead to favoritism or, in worst case scenarios, bias and discrimination.
Philanthropic Paternalism: Traditionally, those who run nonprofit organizations and other community groups tend to be those who already have access to a community’s resources. This can leave a power imbalance between those who are serving and those who are being served, which may lead to organizations believing they “know what’s best” for beneficiaries and giving beneficiaries no control over resources spent on their behalf. This may also mean that those in charge choose programs, activities and services that they personally perceive as valuable (from a position of relative privilege), while potentially ignoring the real needs of those they mean to serve.
Philanthropic Amateurism: Many organizations are led by individuals who do not have management expertise or experience. This is partly due to paternalism, where good intentions and outdated assumptions lead to ill-managed programs. It’s also due to the lack of training and development in the nonprofit sector as a profession where specific skills and expertise are needed.
Critical Conversation
Read the following article by Davarian Baldwin in Nonprofit Quarterly: “Universities and Cities: Why We Must End the Nonprofit Path to Wealth Hoarding” and consider the following questions:
1. Would you consider Baldwin’s description of the role of universities as voluntary failure? Why or why not?
2. If you did, which of Salamon’s four dimensions of voluntary failure seem to relate most closely to what Baldwin is discussing?
3. Do you agree with the potential policy solutions recommended by Baldwin? Which one resonates with you the most?
Interdependence Theory
Due to the Four Failures, nonprofit organizations and government are mutually dependent on each other for providing services that the public needs and demands. Nonprofit organizations (due to voluntary failure) are dependent upon government for the financial resources necessary to do their work, and the government (due to government failure) is dependent on the nonprofit sector to “fill the gaps” left by its own limitations and constraints. Sometimes the government may not directly produce a service, but rather they provide for one through the allocation of funds through grants and contracts to the nonprofit sector. This can be called interdependency theory.
Social Origins Theory
One final theory that I’d like to include in this chapter (there are many others) is Social Origins Theory[9]. This theory provides a good framework to understand the variation in nonprofit sectors in different countries. For example, most higher-income countries have a substantial social safety net for citizens in need. In these countries, the nonprofit sector doesn’t have as many human services organizations as we do in the United States. In countries that lack basic services, such as schools and medical care, the nonprofit sector may be focused on those activities. In countries that limit free speech or advocacy, there may be few, if any, organizations engaged in advocacy or activism.
Discussion Questions
• Define the four failures.
• Why does the nonprofit sector get involved in responding to market failure or government failure? What is their role?
• Why do the types of nonprofit organizations and their roles in society differ around the globe? How do these differences reflect on the nonprofit sector in various parts of the world?
1. Richard Steinberg, “Economic Theories of Nonprofit Organizations,” in The Non-Profit Sector: A Research Handbook, ed. Walter W. Powell and Richard Steinberg, Second Edition (New Haven, CT: Yale University Press, 2006), 117–39.
2. Lueken, “Defining Market Failure (with Examples),” EdChoice, May 24, 2018, https://www.edchoice.org/engage/defi...with-examples/.
3. Lester M. Salamon, “Of Market Failure, Voluntary Failure, and Third-Party Government: Toward a Theory of Government-Nonprofit Relations in the Modern Welfare State,” Nonprofit and Voluntary Sector Quarterly 16, no. 1–2 (January 1, 1987): 29–49, https://doi.org/10.1177/089976408701600104.
4. Alec Wreford and Ian Clark, “Median Voter Theorem – Atlas of Public Management,” 2018, https://www.atlas101.ca/pm/concepts/...voter-theorem/.
5. Salamon, “Of Market Failure, Voluntary Failure, and Third-Party Government.”
6. Peter Frumkin, On Being Nonprofit: A Conceptual And Policy Primer (Cambridge, MA: Harvard University Press, 2005).
7. Salamon, “Of Market Failure, Voluntary Failure, and Third-Party Government.”
8. Salamon.
9. Lester M. Salamon and Helmut K. Anheier, “Social Origins of Civil Society: Explaining the Nonprofit Sector Cross-Nationally,” Voluntas: International Journal of Voluntary and Nonprofit Organizations 9, no. 3 (1998): 213–48, https://doi.org/10.1023/A:1022058200985. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.02%3A_Theories.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Define a nonprofit’s mission and vision statements.
• Explore some of the ethical issues and obligations facing nonprofit organizations and the nonprofit sector.
• Link nonprofit accountability to ethical behavior.
Chapter Introduction
Nonprofit organizations are both similar to and different from for-profit businesses and government agencies, and they also have unique attributes. Due to their tax-exempt status and requirement to behave in the public interest, one of the unique attributes of the nonprofit sector is that it is often held to a very high standard of behavior.[1] They have important ethical and legal responsibilities that they must pay attention to, lest they end up on the front page of the newspaper or harm people. Nonprofit organizations have serious obligations to the public that should always be front-of-mind, from maintaining the public trust to protecting and acting in the best interests of their constituents, clients and beneficiaries. In this chapter, we will discuss the role of a nonprofit’s mission statement and vision in guiding their behavior, the expectations for accountability nonprofits have to meet and the ethical dilemmas they must avoid.
The nonprofit mission
All nonprofit organizations have a mission statement: a “succinct description of the basic purpose of the organization.”[2] A mission statement helps to define and guide the organization’s activities. Usually only a couple of sentences long, a good mission statement should include:
• The nature of the work.
• The reason the organization exists.
• The clients/constituencies they serve.
• The organization’s principles and values.
Additionally, a good mission statement should be broad enough to allow the organization to grow, adapt and add new programs and activities. However, it shouldn’t be too broad, as the community needs a good idea of what the organization’s purpose is.
Activity 1
In groups, look up four different types of nonprofit organizations and find their mission statements on their websites.
• A community garden organization
• An international humanitarian organization
• A civil rights organization
• A local ballet company or symphony
1. Discuss their differences and similarities. Do they discuss their: Purpose? Reason for existing? Who they serve? Their principles and values?
2. Review their websites. If you were to re-write their mission statements, what would you include? As a group, write a first draft of a new mission statement for one organization.
Nonprofit Accountability
To be accountable is “to answer to one’s behavior.”[3] Calls for accountability in nonprofit organizations have been increasing over the past several decades, particularly when there is a scandal involving a nonprofit organization or the people who work for one (see the examples in the introduction).
Nonprofits fail to be accountable when they:
• Fail to follow their mission statement.
• Misappropriate funds (spending money on something different than what was said).
• Steal money.
• Mislead the public about what they are doing.
• Discriminate against their staff, their clients, volunteers or members of the public.
• Are wasteful.
• Fail to share financial information when asked.
• Can you think of others?
Nonprofits are also unique from other types of organizations because they are accountable to a wide variety of stakeholders. Stakeholders are those individuals or groups who are interested in what your organization is doing and whether or not it is meeting its mission.
Nonprofit stakeholders are different from those of businesses, which are most concerned about their owners or shareholders. They are also different from those of government, which is most accountable to citizens and voters. Nonprofit organizations have stakeholders both internally (volunteers, staff, board) and externally (the public, media, regulators). Additionally, they are accountable “upwards” to key stakeholders, as well as “downwards” to others. [4] The following table illustrates who these stakeholders might be:
Nonprofits are accountable for activities that they are expected to engage in (based on their mission), as well as the organization’s performance, finances and legal compliance. Helmut Anheier[5] argues that accountability includes transparency of the organization’s activities along with the behavior of their board members and employees. He argues that it’s crucial for nonprofit managers to have a “culture of transparency” to help ensure accountability. Transparency can include:
• Honesty in fundraising.
• Clear communication with donors and supporters.
• Fiscal accountability (who is responsible for what when it comes to managing the organization’s money and its accounting practices).
• Posting financial information on the organization’s website.
Some organizations, such as CharityNavigator or GuideStar, have set up websites where individuals can review available public information about organizations, including their most recent financial filings and other documents submitted to provide transparency.
Nonprofit Ethics
Running an ethical organization should be a top priority for nonprofit managers. Ethics are “well-based standards of right and wrong that prescribe what humans ought to do, usually in terms of duties, principles, specific virtues, or benefits to society.”[6] Although this definition applies to individuals, organizations can also act ethically or unethically. If organizations act unethically, they can do harm, fail to meet their missions or face scandals that can lead to significant public embarrassment, lawsuits or even being forced to close down.
Activity 2
Individuals and organizations generally know what clear lines are drawn in their organizations (for example, don’t steal), but staff, volunteers and board members can “get in trouble” when there is no clear distinction between right and wrong. Consider the following short scenarios. Are they potential ethical issues? Why or why not? What would you do in these situations?
1. You are an organization that works on child health. Your local fast food chain would like to make a large contribution in support of your “Activate Child Health” day at the local elementary school.
2. Your sports organization is offered a contribution that will double your annual budget, but you are told you can’t accept clientele who are transgender or gender non-conforming unless they are willing to participate as their “assigned gender at birth.”
3. Your staff have worked very hard over the last year, particularly in recovering from the Covid-19 pandemic. You want to acknowledge their great and hard work by providing a significant bonus and throwing a party at a local country club.
4. A board member suggests their company, an accounting firm, should be hired by your organization to complete and file the annual financial reports.
5. Your organization is having trouble paying rent this month because donations are down. There are some leftover funds from a grant you received from a big local foundation. Your board chair suggests you use that leftover money to pay the rent.
Unethical behavior by nonprofit organizations can include the following:
• Violation of your mission (what you say you are going to do).
• Discrimination.
• Fraud or embezzlement.
• Inappropriate fundraising practices.
• Failing to file your annual financial statements and forms on time.
• Accumulating too much profit and not spending it on the mission.
• Issues with salaries and benefits inside the organization.
• A lack of diversity among staff or board members.
• Self-dealing or self-interested behavior by board members or staff (called a conflict of interest).
Critical Conversation
Read the assigned case study, “Standards for Child Sponsorship Agencies: Part A” (2002) by Esther Scott and Dave Brown. Before you come to class, consider the following questions:
• Based on the information provided in the case, who are child sponsorship agencies accountable to? Who are they most worried about offending?
• How do you feel about their fundraising program? Do you think they are being transparent with donors about where their money is going? Why or why not?
• Make a list of the potential ethical problems you see in this case. Why did you add them to your list?
1. Alnoor Ebrahim, “The Many Faces of Nonprofit Accountability,” in The Jossey-Bass Handbook of Nonprofit Leadership and Management, ed. David O. Renz (John Wiley & Sons, 2010).
2. Gary M. Grobman, An Introduction to the Nonprofit Sector, 4th edition (Harrisburg, Pennsylvania: White Hat Communications, 2015).
3. Helmut K. Anheier, Nonprofit Organizations: Theory, Management, Policy, 2nd ed. (New York: Routledge, 2014), http://books.google.com/books?hl=en&...fnd&pg=PP1&dq="edition published in the Taylor and Francis e-Library," "purchase your own copy of this or any of Taylor & Francis or" "2005 Helmut K." "known or hereafter invented, including photocopying and" &ots=XwI7vdB88A&sig=SK_snvwMXOI0aEPXu2Kj0Q3O73U.
4. Ebrahim, “The Many Faces of Nonprofit Accountability.”
5. Anheier, Nonprofit Organizations.
6. Craig E. Johnson, Meeting the Ethical Challenges of Leadership: Casting Light Or Shadow (SAGE Publications, 2007), 10. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.03%3A_Mission_Ethics_and_Accountability_in_the_Nonprofit_Sector.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Understand the ways nonprofit organizations interact with government.
• Understand the theory of government-nonprofit relationships.
• Gain practice considering the challenges and opportunities involved when a nonprofit works closely with government.
Chapter Introduction
Many nonprofit organizations work closely with government at the federal, state and local level in the United States. International nonprofits may work closely with their own federal governments, the governments where they work or international agencies like the United Nations or International Monetary Fund. Alternatively, organizations may work in conflict with government(s) through their advocacy efforts. This chapter covers the different ways nonprofit organizations interact with government and government agencies, from close partners to adversaries.
Shape(s) of Nonprofit-Government Relationships
Relationships between nonprofit organizations and governments take many forms in both theory and practice. These relationships may include:
• Contracts.
• Grants.
• Third-Party Payments.
• Tax-deductions and Tax Exemptions.
• Joint Ventures (Public-Private Partnerships).
• Privatization.
• Advocacy.
• Policy change.
Nonprofit organizations as partners to government
As discussed in Chapter 2, the nonprofit sector has a crucial role in providing much needed services and programs that government is either not able or willing to organize itself. However, government often provides funding – through grants and contracts – that supports the delivery of public goods and human services by nonprofit organizations to the public. This requires a close partnership between government and nonprofit organizations.[1] In Chapter 2, we called that interdependence theory; government depends on the nonprofit sector to deliver services, while the nonprofit sector depends on government for funding.
The following examples demonstrate the many ways government and the nonprofit sector work together.
Tax Deductions and Tax Breaks
Almost all organizations in the nonprofit sector interact with government through tax exemption. The U.S. federal government forgoes literally billions of dollars in tax revenue every year by allowing most nonprofits to be exempt from paying taxes on their revenues. Most state and local governments also extend tax exemption to nonprofits in their jurisdictions. In exchange, nonprofits agree to a few rules, including: 1) acting in the public interest, 2) being transparent about finances and 3) having a board of directors that will provide oversight of the organization. These requirements ensure shared leadership of nonprofit organizations and allow public scrutiny of their finances.[2]
Privatization
Sometimes government steps back from providing a service altogether, turning the services and programs over to the private sector (both businesses and nonprofits). Privatization is “the act of reducing the role of government or increasing the role of the private institutions of society in satisfying people’s needs; it means relying more on the private sector and less on government.”[3] Governments often engage in privatization measures in order to “shrink” the size of government, find new efficiencies and save taxpayer dollars. There are different types of privatization efforts, from grants and contracts to full divestment.[4]
• Contracts. The United States federal government, states and local governments enter contracts with external vendors, including nonprofit, for-profit and other government agencies, to carry out its work. Contracts are the “mutually binding legal relationship obligating the seller [contractor] to furnish the supplies or services (including construction) and the buyer [federal government] to pay for them.”[5]
The nonprofit sector receives billions of dollars annually through federal, state and local contracts to deliver particular services, projects and programs that the government is, by law, required to provide. Among nonprofits, healthcare nonprofits have the highest proportion of contracts, followed by organizations focused on the environment and animals and other social services.[6]
Discussion
In some cases, government opts to allow private organizations to take over a service typically administered by government. This is called contracting out. For example, in 2022, Hillsborough County in Florida contracted out their entire child protective services to a nonprofit, The Children’s Network of Southwest Florida. Interestingly, the organization didn’t submit their own bid for the contract. Instead, the state recruited them to provide the service.
Read the article linked above and answer the following questions:
1. What is the goal of government wanting to contract out child protective services to a nonprofit rather than doing it themselves?
2. Why might the nonprofit be interested in providing the service? What challenges might they face?
• Grants. On the other hand, grants are “authorized expenditure[s] to a non-federal entity for a defined public or private purpose in which services are not rendered to the federal government.”[7] Grants are usually given for a specific purpose to benefit project or program development in organizations. They do not have to be paid back. While most federal grants are provided to state and local governments, some nonprofit agencies are able to apply for them. In addition, nonprofits often compete for grant funding from their states, counties and municipalities as well. The below graphic[8] shows how the federal government, state and local agencies and nonprofit organizations interact in terms of grants and contracts.
Public-Private Partnerships (PPP)
PPP occur when government agencies and nonprofit or for-profit organizations collaborate to jointly define and develop a product, project or service. PPP are one way that organizations help to leverage the finances, management, ideas and leadership available across the three sectors.[9]
The San Diego Regional Policy & Innovation Center is a new partnership between the County of San Diego, CA, the San Diego Foundation and the Brookings Institution, a leading nonprofit think tank. It was founded in 2021 and, as its own nonprofit organization, is designed to: “develop, test and implement world-class research and policy-driven solutions to address our region’s most pressing challenges. We use applied research to help local leaders identify catalytic policies, programs, and interventions and attract greater capital to the region.” Read the following article: https://www.sandiegouniontribune.com/news/politics/story/2021-09-27/new-partnership-brookings-foundation
• What is the Policy and Innovation Center seeking to do?
• Why do they feel like their approach as a Public-Private Partnership is the right one to solve social issues?
Benefits and Challenges of Nonprofit-Government Partnerships
An outstanding question is: why do government and nonprofit organizations seek partnerships, whether through collaboration or contracts and grants?
A government agency may want to partner with nonprofit organizations to help cut costs to taxpayers. This contracting out has been a trend in government over the past several decades. Whether it’s a desire to “shrink the size” of government or identify competencies and expertise not held by the agency, contracting out aims to ensure that the program is being provided without government having to undertake it.[10]
Government agencies may also be interested in working through nonprofit agencies to leverage the nonprofit’s positive community reputation, particularly among constituencies that may be otherwise hard to reach – such as immigrants or the unhoused population. In some ways, this can be seen as government understanding Contract Failure from Chapter 2 and using this to its advantage in delivering a public service.
Nonprofits, on the other hand, may look forward to the additional financial resources of partnerships, allowing them to grow their organizations, build their capacity to do more work and provide financial stability. They may also enjoy more influence among policymakers or over policy processes and gain further legitimacy with other donors.
However, these relationships can be challenging. For one, contracting out services to third parties can make identifying lines of accountability difficult when something goes wrong; each side can easily blame the other. Additionally, nonprofits may find the added burden of additional red tape – usually through oversight or filing reports and updates – difficult to manage effectively. Nonprofits may also find themselves working on issues outside their stated mission (sometimes called mission drift).
Critical Conversation
Mission drift, or mission creep, has often been seen as a bad thing[pdf] to be avoided at all costs by the nonprofit sector. Although it’s true that organizations may become stretched too thin, and even end up engaging in activities not aligned with their mission statement, some scholars have recently started to encourage nonprofit leaders to think more critically about the issues of “mission drift” in their organizations. Read this article by Vu Le, a leading blogger and thinker about the nonprofit sector in the United States. Consider the following questions:
• Why do some people think that mission drift shouldn’t be avoided at all costs by organizations?
• What are the downsides of strictly adhering to a mission? Or developing a very narrow mission?
• How should managers think about mission drift instead?
Nonprofits as Advocates and Adversaries to Government
Although many nonprofits work closely with government agencies to implement programs and public services, many nonprofits also engage in advocacy efforts. Advocacy is “speaking or acting on the behalf of others.”[11] Chapter 7 discusses nonprofit advocacy in much more detail.
Advocacy, and even lobbying, isn’t just undertaken by “political” organizations. Nonprofit organizations engage in advocacy for many reasons, including to: advocate for public funding to support certain organizations and issues; raise awareness within the communities they work with; help refine or change existing public policy to better serve their constituents; lobby for policy change at the local, state, federal or international levels; and help people understand policy issues and connect them to their representatives.
A lot of advocacy efforts can be adversarial, with organizations challenging government agencies and legislatures to be more responsive to social issues and problems. However, advocacy can also be participation in political processes, including serving on local commissions and committees or working with government agencies to define a new grant proposal process. In these ways, nonprofit organizations can be involved in policy processes and changes at all different levels of government.
Advocacy in Action
Watch the first few minutes of Keenya Robertson testifying before the U.S. House of Representatives Committee on Appropriations in 2019 (start at about the 22 minute mark). Mrs. Robertson is the Board Chair of the National Fair Housing Alliance and President and CEO of Housing Opportunities Project for Excellence, Inc. Consider the following questions:
• What is Mrs. Robertson’s priority?
• What is she asking Congress for?
• Did she share information about the problems faced by the people her organization serves? How did she do that?
1. R. Smith and Kirsten A. Grønbjerg, “Scope and Theor of Government-Nonprofit Relations,” in The Non-Profit Sector: A Research Handbook, ed. W. W. Powell and Richard Steinberg, Second (New Haven, CT: Yale University Press, 2006), 221–42.
2. Candid Learning, “Trainings in Nonprofit Fundraising, Proposal Writing, Grants,” Candid Learning, accessed May 2, 2022, https://learning.candid.org/resource.../pros-and-cons;
3. E S Savas, Privatization and Public-Private Partnerships (Chatham, NJ: Chatham House, 2000), 2.
4. Savas, Privatization and Public-Private Partnerships.
5. “Part 2 - Definitions of Words and Terms | Acquisition.GOV,” Acquisition.Gov, accessed April 7, 2022, https://www.acquisition.gov/far/part-2.
6. Sarah L Pettijohn and Elizabeth T Boris, “Contracts and Grants between Nonprofits and Government,” 2013, 8.
7. USASpending.gov, “Glossary,” accessed May 2, 2022, https://usaspending.gov/.
8. National Council of Nonprofits, “Toward Common Sense Contracting: What Taxpayers Deserve” (Washington, DC: National Council on Nonprofits, 2014), https://www.councilofnonprofits.org/...rs-deserve.pdf.
9. STUART C. MENDEL and JEFFREY L. BRUDNEY, “PUTTING THE NP IN PPP: The Role of Nonprofit Organizations in Public-Private Partnerships,” Public Performance & Management Review 35, no. 4 (2012): 617–42.
10. Anna A. Amirkhanyan, “Monitoring across Sectors: Examining the Effect of Nonprofit and For-Profit Contractor Ownership on Performance Monitoring in State and Local Contracts,” Public Administration Review 70, no. 5 (2010): 742–55, https://doi.org/10.1111/j.1540-6210.2010.02202.x; Michael Lipsky and Steven Rathgeb Smith, “Nonprofit Organizations, Government, and the Welfare State,” Political Science Quarterly 104, no. 4 (1989): 625–48, https://doi.org/10.2307/2151102.
11. Kelly LeRoux and Mary K Feeney, Nonprofit Organizations an Civil Society in the United States (New York: Routeledge, 2015). | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.04%3A_Government-Nonprofit_Relationships.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Define volunteering and volunteerism.
• Understand why people volunteer.
• Recognize how organizations use volunteers.
Chapter Introduction
So far in this book, we have covered the theories and the “why” of many issues that nonprofit managers have to consider when running their organizations. We have also discussed how scholars think about nonprofit organizations, their activities and their role in society. This chapter begins to look at how nonprofit organizations organize their resources and work for change, starting with volunteers and voluntary action.
Approximately one third of Americans – almost 80 million people – volunteer every year.[1] Additionally, scholars have estimated nearly 1 million people volunteered internationally every year before the Covid-19 pandemic curtailed international travel.[2] In 2016, the U.S. Bureau of Labor Statistics reported that women are more likely to volunteer than men and the most active age group were those 35-44 years old.
The impact of these volunteers on organizations can’t be under-estimated. Many, if not most, nonprofit organizations rely upon volunteers to support their activities. Smaller organizations may have no paid staff and are completely organized and managed by volunteers. Additionally, almost all nonprofit organizations have a volunteer board of directors providing oversight of the organization. This chapter will first discuss how volunteers are defined, who volunteers and why people volunteer. It will end with a discussion about what managers might want to consider in running a successful volunteer program for their organization.
Defining volunteering
Believe it or not, there are many different ways to define volunteering. Broadly, volunteering is unsalaried service[3] and is “any activity in which time is given freely to benefit another person, group or cause.”[4] However, while it is undertaken as part of an individual’s leisure time, it is also often considered “work”[5] making its classification difficult. Most definitions of volunteering include the following four key elements: [6]
• free will.
• no financial reward.
• helping strangers/beneficiaries.
• conducted through an organization.
However, this doesn’t take into account different motivations people have to help and the types of volunteering available. Although volunteering is usually done without a financial reward, individuals can and often do receive a benefit of some sort. For example, they may receive recognition for their service, free t-shirts, free food or free membership with an organization in exchange for their service. In addition, a definition requiring work for a formal organization ignores the fact that much voluntary action is conducted outside of formal organizations.
Informal volunteering is “unpaid, non-compulsory work: that is, time individuals give without pay to activities performed either through an organization or directly for others outside their own household.” Two examples of informal volunteering are driving an elderly neighbor to a doctor’s appointment or watching your neighbors’ children for free if they need a babysitter. Higher rates of informal volunteering – through supporting each others’ communities – are seen among women, people of color and those with lower-incomes. This can lead to negative stereotypes about marginalized communities, creating a belief that they aren’t somehow involved in serving their communities.[7] Most measurements of volunteering in the United States don’t take informal volunteering into account, which can leave many helping behaviors and voluntary actions hidden from view and thus undervalued.
Discussion
Covid-19 and Volunteering
When the Covid-19 pandemic shuttered businesses, churches and nonprofit organizations across the country in early 2020, some individuals stepped up to help their neighbors in need. Read this article about one individual’s effort in the San Francisco Bay Area and discuss the following questions:
• Would you consider Mr. Pham’s efforts in his community formal or informal volunteering? Why or why not?
• What were other strategies taken by others equally concerned about food insecurity during the pandemic?
• How have you and your family or friends engaged in informal volunteering? Formal volunteering?
Why Do People Volunteer
While defining volunteering can be challenging, understanding why people volunteer is also difficult, as people volunteer for a diverse set of reasons. They may be motivated by instrumental reasons, like adding to a resume, being social with others, the social environment they live in or a sense of reciprocity they share with their community members, friends and family.
For example, some scholars take a functional approach, suggesting that volunteer motivations serve different functions, or needs, of individuals.[8] These functions may include an interest in expressing their values, learning about the world, personal growth, career development, an interest in social interaction or trying to lessen feelings of guilt or obligation.
Volunteers may be motivated by religious or spiritual obligations or values, a desire to provide community support or life-changing events that may change values and priorities.[9] People may also volunteer for different reasons at different times of their lives.[10]
Both in the United States and internationally, different cultural, ethnic and racial groups may have different reasons for volunteering. Latino/a/x communities, for example, may volunteer for more family-oriented reasons[11], while religion is shown to be an important factor for African-American communities.[12] Informal volunteering is slightly more predominant than formal volunteering in Black and Hispanic/Latino communities[13] but the opposite is true for people with disabilities.[14]
Valuing Volunteering
Nonprofit scholars and practitioners are also very interested in measuring the economic impact of volunteers. But, how do you measure the value of a volunteer when they are not paid for their services? There are a few different ways practitioners may consider the value of volunteer work within their organization.[15]
One way managers can measure the value of volunteering is to consider the opportunity cost of a volunteer’s time. In other words, what would a volunteer have earned if they were working instead of volunteering their time? While it may be easy to calculate what a volunteer may have earned for the same amount of time in any current employment they have, it is much more difficult to measure the value of the leisure time that individuals are foregoing in order to volunteer.
Managers can also measure the replacement cost of their volunteers. That is, how much would the organization have to pay if they hired someone to do the work a volunteer can do? Although this is more straightforward, there are many volunteer positions – such as donating blood, preparing and delivering meals to the elderly, helping with your church’s yard sale or coaching your kids’ sports team – for which there is no clear market comparison. In addition, how would you replace someone with a paid employee in positions that are almost exclusively held by volunteers – such as board service?
Last, managers can assess organizational value – or the way the organization values their volunteers’ efforts. This is intangible value that may be impossible to place a monetary figure on. Volunteers are ambassadors for the organization, can provide networking opportunities in order to identify collaborative partnerships and may be a key feature of the organization’s values and culture.
Volunteers and the American Red Cross
In Chapter 1 you were introduced to the role of the American Red Cross (ARC) when you were thinking about instrumental vs. expressive organizations. Did you know that 90% of ARC’s workforce are volunteers? Over 300,000 volunteers engage in a variety of activities, from responding to house fires to installing fire alarms to responding to disasters by staffing shelters and providing mental health care, spiritual care and case management. Volunteers also lead local chapters, conduct local fundraising and help to spread awareness about ARC’s activities in their communities. How would you measure the value of these volunteers to the organization?
Considerations for Managers
The challenges facing volunteer managers are complex. How do you match volunteer motivations with the tasks your organization needs? As discussed above, volunteers come to nonprofit organizations for a diverse set of reasons; a successful manager will try to match a volunteer’s interests with positions they need filled in their organization. For example, if you have a volunteer who is looking for something to do in their spare time that offers a social outlet, assigning them to tasks done independently will likely lead to that volunteer not returning to help the organization.
Managers also need to consider what tasks within their organization would best be filled by a volunteer rather than built into the job description of a paid employee. This should be done strategically as part of a larger conversation about staffing needs in organizations.
Lastly, volunteers need to be supported in their roles, or they will lose their motivation and fail to return. Hager and Brudney assert, “unless organizations pay attention to issues of volunteer management, they will not do a good job of recruiting, satisfying, and retaining volunteers.”[16]
To manage volunteers, many leaders use practices and structures recommended by scholars and practitioners that closely resemble other human resource management (HRM) practices used by businesses to hire, train and manage employees.[17] When organized well, volunteering can help meet the social, psychological and professional needs of individuals and help organizations improve their impact. Some questions that managers must consider in launching a volunteer management program are:
• Who will be responsible for managing volunteers?
• What do you need volunteers for? How long do you need them for?
• Where will you find volunteers?
• What training will they require in order to fill their role(s)?
• How will you keep them motivated?
Activity 1
Develop a Volunteer Management Plan
You are the volunteer manager for the local NAACP chapter that runs a mobile food pantry like this one in partnership with the local food bank, among other programs. Since your organization would like to expand the program to take place in more locations and for more hours every week, your supervisor has asked you to put together a new volunteer plan for the program. Take a few minutes to think about how you would answer the following questions:
• What tasks might you use volunteers for? Who are your ideal volunteers? What are their likely motivations?
• How will you recruit them? (Where will you find them?)
• What type of training will they need to be successful?
• What type of support can your organization provide to keep them motivated and engaged?
• How will you measure their contributions to your mission?
Bonus: Sketch out what a volunteer job description might look like for this role.
Adapted from: Jones, J. A. (2020). “Volunteer management: introducing students to the art and the science.” Management Teaching Review, 5(2), 163-171.
Summary
In this chapter we discussed the reasons why people might volunteer for organizations, the difference between formal and informal volunteering and some considerations managers may want to integrate into a successful volunteer program. One key lesson is that volunteers are not free to organizations. Working with volunteers in nonprofit organizations requires that managers use volunteers strategically and in ways that will leave both the organization and the volunteer enriched by their service. This takes intentionality and planning to do well. Many organizations may even hire professional staff whose sole job is volunteer recruitment, training and support.
1. US Census Bureau, “National Volunteer Week: April 17-23, 2022,” Census.gov, accessed May 4, 2022, https://www.census.gov/newsroom/stor...teer-week.html.
2. Benjamin J Lough, “A Decade of International Volunteering from the United States, 2004 to 2014,” Research Brief (St. Louis, MO: Center for Social Development, 2015).
3. Ram A. Cnaan, Femida Handy, and Margaret Wadsworth, “Defining Who Is a Volunteer: Conceptual and Empirical Considerations,” Nonprofit and Voluntary Sector Quarterly 25, no. 3 (1996): 364–83.
4. John Wilson, “Volunteering,” Annual Review of Sociology 26 (2000): 215.
5. Lester Salamon, Megan A. Haddock, and S. Wojciech Sokolowski, “Closing the Gap? New Perspecitives on Volunteering North and South,” in Perpsectives on Volunteering: Voices from the South, ed. Jacqueline Butcher and Christopher J Einolf (Switzerland: Springer International Publishing, 2017), 29–52.
6. John Wilson, “Volunteerism Research A Review Essay,” Nonprofit and Voluntary Sector Quarterly 41, no. 2 (April 1, 2012): 176–212, https://doi.org/10.1177/0899764011434558.
7. Jon Dean, “Informal Volunteering, Inequality, and Illegitimacy,” Nonprofit and Voluntary Sector Quarterly, July 27, 2021, 08997640211034580, https://doi.org/10.1177/08997640211034580.
8. E. Gil Clary and Mark Snyder, “The Motivations to Volunteer: Theoretical and Practical Considerations,” Current Directions in Psychological Science 8, no. 5 (October 1, 1999): 156–59.
9. James L Perry et al., “What Drives Morally Committed Citizens? A Study of the Antecedents of Public Service Motivation,” Public Administration Review 68, no. 3 (May 1, 2008): 445–58, https://doi.org/10.1111/j.1540-6210.2008.00881.x.
10. Takashi Yamashita et al., “Underlying Motivations of Volunteering Across Life Stages: A Study of Volunteers in Nonprofit Organizations in Nevada,” Journal of Applied Gerontology 38, no. 2 (February 1, 2019): 207–31, https://doi.org/10.1177/0733464817701202.
11. Beverly B. Hobbs, “Diversifying the Volunteer Base: Latinos and Volunteerism,” Journal of Extension 39, no. 4 (2001): 46–53.
12. Ian A. Gutierrez and Jacqueline S. Mattis, “Factors Predicting Volunteer Engagement Among Urban-Residing African American Women,” Journal of Black Studies 45, no. 7 (October 1, 2014): 599–619, https://doi.org/10.1177/0021934714543189.
13. Young-joo Lee and Jeffrey L. Brudney, “Participation in Formal and Informal Volunteering: Implications for Volunteer Recruitment,” Nonprofit Management and Leadership 23, no. 2 (2012): 159–80, https://doi.org/10.1002/nml.21060.
14. Carrie L. Shandra, “Disability and Social Participation: The Case of Formal and Informal Volunteering,” Social Science Research 68 (November 1, 2017): 195–213, https://doi.org/10.1016/j.ssresearch.2017.02.006.
15. Laura Leete, “The Valuation of Volunteer Labor,” in Handbook of Research on Nonprofit Economics and Management, Bruce A. Seaman and Dennis R. Young (Eds.) (Northampton, MA: Edward Elgar Publishing, 2010), 238–48.
16. Mark A. Hager and Jeffrey L. Brudney, “Problems Recruiting Volunteers: Nature versus Nurture,” Nonprofit Management and Leadership 22, no. 2 (December 1, 2011): 2, https://doi.org/10.1002/nml.20046.
17. Kerstin Alfes, Bethania Antunes, and Amanda D. Shantz, “The Management of Volunteers – What Can Human Resources Do? A Review and Research Agenda,” International Journal of Human Resource Management 28, no. 1 (January 2017): 62–97, https://doi.org/10.1080/09585192.2016.1242508. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.05%3A_Volunteers_and_Voluntary_Action.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Understand why people give to nonprofit organizations.
• List the ways nonprofits access financial resources.
• Consider contemporary critiques of philanthropy.
Chapter introduction
Despite the Covid-19 pandemic, or perhaps because of it, charitable giving in the United States reached an all-time high in 2020: \$471 billion, a 15% increase over the previous year.[1]
Perhaps this shouldn’t be a surprise, but nonprofit organizations usually need financial resources in order to meet their mission as organizations. Larger organizations need to pay staff salaries, pay to implement their programs and pay rent and utilities. Even small, community-based organizations without staff often require a modest budget to be able to implement their plans – from purchasing necessary supplies and equipment, to marketing their work (printing flyers and brochures, media campaigns), to reimbursing volunteers for travel expenses. It seems sometimes that nonprofit organizations are always on the hunt for more resources to support their work.
In this chapter, we will discuss the various revenue streams that organizations use to raise the funds they need. We will also cover some of the leading theories that explain why people give money to nonprofit organizations. We will finish with a short discussion of some of the critiques of philanthropy in the United States and around the world.
Defining philanthropy and charitable giving
Although I think we all know what philanthropy means, there is quite a bit of diversity for the terms used by scholars and practitioners. Merriam-Webster defines philanthropy as “goodwill to fellow members of the human race.” While it usually relates to financial donations, sometimes “gifts” of time (volunteering) is also included (see Chapter 5 for more on volunteering).[2] It is often perceived as altruistic, benefitting others.
When people think of philanthropy, they often first think of wealthy individuals who give a significant amount of their wealth away through one form or another – from a single gift to a favorite organization to setting up a family foundation in their name. Those foundations then make their own grants to organizations, sometimes for decades or longer. Take a look at MacKenzie Scott as she seeks to give away a significant proportion of her wealth.
Foundations
Foundations are a specific type of nonprofit organization, often with a primary goal to help collect and distribute money to other nonprofit organizations. The Council of Foundations defines a foundation as “an entity that supports charitable activities by making grants to unrelated organizations or institutions or to individuals for scientific, educational, cultural, religious, or other charitable purposes.” These organizations must pay out at least 5% of their assets each year in grants.
Private foundations are founded by an individual, family or corporation.
Public Charities may also provide grants to other individuals and organizations, but they are generally supported by the public at large, rather than a single person or business. Community foundations are included in this category, as they raise their money and often distribute those funds in specific communities.
Explore more about foundations at the Council on Foundations.
Charitable giving, on the other hand, often means any gift of money, time, goods or services to those in need. It also usually refers to individual gifts, rather than institutional gifts from foundations or corporations.
Both scholars and practitioners often use these two terms – philanthropy and charitable giving – interchangeably.
Charitable giving across cultures and faiths
Like volunteering, different groups of people tend to give money away to charity differently. Different parts of the country tend to give at different rates, and “blue states” tend to give less than “red states.” The main driver for this seems to be religious practice. Those who attend religious services more frequently tend to give more often – and even give more – than those who don’t.
Among different racial and ethnic group, Black donors tend to donate a higher proportion of their wealth than white donors. This trend also holds for the Latino/a/x and Asian communities.
Why people give
One of the big challenges facing scholars who study charitable giving and philanthropy is understanding why people donate money to causes and organizations that they do not directly benefit from. Classical economics would argue that charitable giving is irrational. That is, in an effort to maximize their own best interest, or maximizing their utility, individuals shouldn’t be expected to give away their wealth with no expectation of any benefit in return. There are several different theories to explain why otherwise self-interested individuals will give money away.
Public goods provision. Economists argue that individuals desire a certain level of public goods in their communities (such as education, the arts, human services), and they will contribute their own money to support the provision of these services up to the point where government steps in to support the provision of the good. In this way, government provision could be seen as crowding-out private philanthropy.[3] In other words, every dollar of government provision for a public good will lead to donors giving one dollar less in charitable giving. Yet, research has found that people do tend to contribute past the point of government funding, leading to only a partial crowding-out.[4]
Impure Altruism and Warm-glow. Economist James Andreoni argued that individuals are rarely purely altruistic.[5] That is, they don’t engage in charitable giving with no real expectation of a benefit. Rather, people are engaged in what he calls impure altruism. He suggests that individuals often give to charity because doing so makes them feel good – what he calls a warm glow. This outcome is a powerful benefit received by the donor that can incentivize them to give away a part of their wealth.
Reputational Concerns. Outside of making a donor feel good, charitable giving can also improve one’s reputation in the community. Since people want to be seen as “good,” charitable giving is one way someone can demonstrate that they are a good person that can be respected.[6]
Signaling. Related to reputational benefits, wealthy people might give financial gifts to organizations in order to signal, or demonstrate, their wealth to their communities.[7]
Peer Pressure. Individuals are influenced by peer pressure; they want to behave in similar ways to others. One tool that has been shown to influence charitable giving is called social information – when giving behavior of others is shown to potential donors, they tend to give in similar ways.[8]
Discussion
Theories of Charitable Giving
In 2013, Jen Shang and Rachel Croson published the results from an experiment with a public radio station conducting a fundraising drive. During these drives, on-air personalities encourage listeners to call-in and make a financial contribution to support the station and the programming they enjoy.
As part of the experiment, potential donors who called in were randomly assigned to different treatment groups. Some donors were informed that a “previous donor” had contributed \$75 (or \$180 or \$300), then asked “How much would you like to pledge today?” The control group in the experiment was not given any information about a previous donor’s gift.
Not surprisingly, donors who received information about previous donors often gave more than those donors who did not receive this information.
Discussion questions:
• For donors who are calling in to the station, what might be one motivation for giving? Which theory or theories might explain why people give to support public radio?
• Which theories were Shang and Croson using in their experiment with the potential donors to potentially increase their gift?
• If you were a fundraising manager, what messages might work best if you think people are motivated by the different theories?
Croson, Rachel, and Jen Shang. “Limits of the Effect of Social Information on the Voluntary Provision of Public Goods: Evidence from Field Experiments.” Economic Inquiry 51, no. 1 (January 2013): 473–77.
How else do organizations raise money?
Believe it or not, individual, foundation and corporate donors give less than 20% of the money that flows into the nonprofit sector every year. Donations from individuals only account for 9% of the nonprofit sector’s revenue.
What surprises you about the image above? To me, the fact that private foundations only account for 2.9% of the revenue of the nonprofit sector is surprising. Corporate donations, too, account for less than one percent!
Instead, the vast majority of the money that nonprofit organizations receive every year – upwards of 80% of it – comes from either government contracts/grants or fees for service.[9] Government contracts and fees for service are often called earned income, where there is a payment of some sort in exchange for a service provided by the organization. Under the fees for service category above, the largest proportion are the fees private insurance pays for medical care and tuition for nonprofit colleges and universities. However, it can also include tickets to a musical concert, or a museum, or the sales at thrift stores run by nonprofit organizations.
One form of earned income, and one that is growing, is social enterprises. We will discuss social enterprises in much more detail in Chapter 8, but for the purpose of fundraising, a social enterprise can be any organization that uses the market to create social value. In this case, any nonprofit that seeks to generate additional money through sales of a good or service could be included in our definition of social enterprises.
Critical Conversation
Can Philanthropy Solve Social Problems?
As we have seen above, donations from individuals are only 9% of the revenue that flows into the nonprofit sector. Many scholars and nonprofit leaders have pointed out that even a significant amount of philanthropy is often not adequate to solve the problems communities face – we discussed this in Chapter 2 when we talked about voluntary failure.
Taking things a step farther, some scholars and community leaders challenge the notion that philanthropy is always a force for good and have become critical of the role of philanthropy in our society. Consider these facts:
Discussion Questions
• Should we just give up on philanthropy as a way to address social problems?
• With so much attention to the social issues many communities continue to face, why have these inequities in charitable giving and beneficiaries been allowed to persist?
• What might be some policy changes to encourage more charitable giving to those most in need?
• What are other options to ensure that those most in need are able to get the services they would benefit from?
1. Haleluya Hadero, “Charitable Giving in the U.S. Reaches All-Time High in 2020,” AP NEWS, June 15, 2021, https://apnews.com/article/philanthr...7827de04e017c0.
2. Robert L. Payton and Michael P. Moody, Understanding Philanthropy: Its Meaning and Mission (Indiana University Press, 2008).
3. Burton A. Weisbord, “Private Goods, Collective Goods: The Role of the Nonprofit Sector Charitable Organizations,” Research in Law and Economics Supplement 1 (1980): 139–70.
4. James Andreoni, “An Experimental Test of the Public-Goods Crowding-Out Hypothesis,” The American Economic Review 83, no. 5 (1993): 1317–27.
5. J. Andreoni, “Impure Altruism and Donations to Public Goods: A Theory of Warm-Glow Giving,” The Economic Journal 100, no. 401 (1990): 464–77.
6. David Reinstein and Gerhard Riener, “Reputation and Influence in Charitable Giving: An Experiment,” Theory and Decision 72, no. 2 (February 1, 2012): 221–43, https://doi.org/10.1007/s11238-011-9245-8.
7. A. Glazer and K. A Konrad, “A Signaling Explanation for Charity,” The American Economic Review 86, no. 4 (1996): 1019–28.
8. J. Shang and R. Croson, “A Field Experiment in Charitable Contribution: The Impact of Social Information on the Voluntary Provision of Public Goods,” The Economic Journal 119, no. 540 (2009): 1422–39.
9. Mark Hrywna, “80% Of Nonprofits’ Revenue Is From Government, Fee For Service,” The NonProfit Times, September 19, 2019, https://www.thenonprofittimes.com/ne...e-for-service/. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.06%3A_Philanthropy_and_Charitable_Giving.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Read about the theories of social movements and advocacy.
• Understand the role of nonprofit organizations in social movements and advocacy.
• Practice advocacy skills.
Chapter Introduction
So far in this textbook you have learned about the service role of nonprofit organizations. You’ve also learned about the ways that nonprofits partner with government to deliver public goods. However, nonprofit organizations are also central players in movements for social and policy change. Sometimes they engage in policy change in partnership with government by serving on commissions, task forces and committees alongside public officials. Other times they are in conflict with government by engaging in efforts to change the status quo and improve public policy to solve social issues, protect the environment and improve human rights protections. Some of these efforts are part of larger social movements, which are often made up of many nonprofit organizations, businesses and community leaders.
As part of their advocacy efforts, nonprofits help to inform the public about issues before policymakers and help to educate policymakers about issues facing communities. They also often represent historically marginalized communities before policymakers and identify potential policy solutions.
In this chapter, we will define advocacy and social movements, describe the roles of nonprofit organizations in engaging in these activities and efforts and learn about different advocacy tactics organizations and individuals can support to create change.
Activity 1
Brainstorm a list of all the ways that individuals and organizations can speak up on community or policy issues. Identify organizations that engage in one or more of the activities you listed.
Defining Advocacy
Simply put, advocacy is speaking or acting on the behalf of others.”[1] It is an umbrella term that includes many different types of advocacy activities – some of which are regulated by the United States government, depending on the type of nonprofit an organization is.
How Nonprofits Advocate
According to Kelly Leroux and Mary Feeney[2], nonprofit organizations engage in several different roles in their advocacy:
• Representation. Nonprofits represent the interests of certain groups before policymakers. Sometimes, that can be taken literally by representing clients in courts through litigation or lawsuits. However, nonprofits often do this through direct lobbying – in Congress, state legislatures, or at the local level – or by presenting petitions or public testimony to decision makers. Through representation, nonprofit organizations help to raise community issues before policymakers and offer solutions for change.
• Political Mobilization. Nonprofit organizations help to mobilize the public. They might do this by organizing petition drives, encouraging people to vote or attend public hearings and rallies or by recruiting and training individuals to lobby their own legislators or do media outreach. Through political mobilization, nonprofit organizations help connect the public to their elected officials.
• Education. Nonprofits also have an important role in education around policy and political issues. They help inform the public about how their representatives vote on particular issues, and they help increase awareness around issues they are working on. Some nonprofits, such as think tanks like the Brookings Institution and other organizations, may conduct their own policy research, researching problems and identifying potential policy solutions.
It’s important to recognize that nonprofit organizations may engage in one or more of these roles simultaneously.
IRS Regulation of Advocacy
In Chapter 1, we discussed the different types of tax-exempt nonprofit organizations defined by the Internal Revenue Service (IRS). The type of nonprofit an organization chooses to become may have implications for what type of advocacy tactics that organization can get involved in. Specifically, the IRS regulates the role of nonprofits in direct lobbying and electioneering (campaigns for office) activities. Lobbying is defined by the IRS as “attempting to influence legislation. A 501(c)(3) charitable organization may engage in some lobbying, but too much lobbying activity risks loss of tax-exempt status.” Note that the IRS doesn’t define what “too much lobbying” is. This definition also doesn’t include meeting with agency secretaries (such as “lobbying” the Environmental Protection Agency). So, in short, lobbying is ONLY about talking to a legislator about legislation (a specific bill). On the other hand, 501(c)(4) social welfare and mutual benefit organizations, along with several other types of organizations, are allowed to engage in unlimited direct lobbying. 501(c)(3) charitable organizations also are not allowed to engage in any electioneering activities except for voter registration, get out the vote drives and a limited amount of voter education as long as it doesn’t endorse a candidate.
501(c)(4) groups can engage in some electioneering, including endorsing candidates and giving money to other nonprofits such as Political Action Committees (PACs). Again, the IRS doesn’t provide a threshold to determine what amount is “too much.”
Because of the ambiguity of some of these rules around advocacy, some groups form more than one nonprofit in order to engage in different activities. For example, HRC (in our example above) has a 501(c)(3), a 501(c)(4) and a Political Action Committee of its own (which allows them to give money directly to candidates for office). Although each of these organizations are legally autonomous, they often operate under a single mission and sometimes are supported by the same group of staff members.
As a nonprofit manager, it’s important to know which type of nonprofit your organization is and what advocacy activities you are able to engage in.
Activity 2
The Human Rights Campaign is a national LGBTQ (lesbian, gay, bisexual, transgender and queer) advocacy organization.
Their mission is “to end discrimination against LGBTQ people and realize a world that achieves fundamental fairness and equality for all. HRC envisions a world where lesbian, gay, bisexual, transgender and queer people plus community members who use different language to describe identity are ensured equality and embraced as full members of society at home, at work and in every community.”
Following a wave of anti-LGBTQ legislation introduced in state capitals across the country in 2022, HRC was not only working at the federal level in Washington, D.C., but was also helping to organize and represent the LGBTQ community nationwide, from Juneau, Alaska to Tallahassee, Florida.
Review HRC’s website. Which role(s) do they play in advocacy? Refer to Leroux and Feeney’s typology of representation, mobilization and education.
Advocacy Activities
Take a minute to think about all the ways that you or your friends and family have worked to “speak on behalf of a cause.” Can you list some of them?
Organizations may use many different types of activities to advance their policy agenda or to stop legislation or laws they oppose. Below is just a sampling. Can you think of others?
• Lobbying – Lobbying is just one form of advocacy activity and one of the only ones that the IRS and some states try to regulate and monitor. Review the box on the IRS definition of advocacy for more information.
• Litigation – Many nonprofits file lawsuits against a local, state or federal government or agency, or sometimes even a corporation. Sometimes nonprofits will file suit in order to enforce implementation of a law or to stop a law from taking effect. They may also seek to change the law through judicial action.
• Grassroots lobbying – There are a lot of activities that fall under this category, including lobby days, petition gatherings, phone banking and letter writing campaigns. Through these activities, nonprofits help citizens communicate their opinions, values and beliefs with lawmakers.
• Raising awareness – Nonprofits are often very active in educating the public about issues before decision makers. Activities that raise awareness may support grassroots lobbying, but they can also be used primarily to help sway public opinion or educate communities on particular issues. These types of tactics include town hall meetings or other types of community gatherings and events, rallies and marches, media outreach and engagement, newsletters or social media posts or dissemination of policy research.
• Electoral activities – Although electoral activities, like lobbying, are regulated by the IRS, nonprofits often are leading actors in candidate and ballot measure campaigns. They help register voters, educate them on the issues and turn them out to vote. Most nonprofits are also able to host nonpartisan candidate forums [pdf], where all candidates for office are invited to share their positions on the issues facing the community. Some types of nonprofits are even able to endorse candidates and provide them campaign contributions or work on their behalf.
• Direct Action and Civil Disobedience – Sometimes using the above tactics isn’t successful in winning the social or policy change that organizations seek. At other times, issues are too urgent to wait for Congress or a state legislature to act. And sometimes communities are frustrated with the lack of action by decision makers. In these cases, nonprofit organizations may sponsor certain types of direct action activities. These activities are designed to generally raise awareness by disrupting public spaces, and may include street blockades, holding a sit in at a local business or government office, strikes, boycotts and tree sitting. The goals of these activities are usually to generate public attention and support through the media and also increase pressure on lawmakers to act quickly.
While some nonprofit organizations may focus on one advocacy technique, many organizations engage in several tactics, sometimes simultaneously. Nonprofit boards of directors and staff are tasked with identifying which tactics may be appropriate based on their mission and goals and their stakeholders’ expectations.
Activity 3
Your voice matters too! Think about an issue you are concerned about. Spend a few minutes researching the basic facts of the issue. Consider exploring the website of a nonprofit that is working on the issue you care about.
Then, write a short letter to the editor to your local newspaper.
Letters to the editor are usually only 100-250 words, under your own name, that summarize an issue, point out the relevant facts people should understand and often suggest a possible solution or a different point of view. Review some examples at The Washington Post before you begin.
Critical Conversation
Can Nonprofits Solve Social Issues Through Advocacy?
Although many, if not most, nonprofits engage in some form of advocacy efforts on behalf of their organization or beneficiaries, community and members, there have been growing demands for nonprofits to do more. This is particularly the case when nonprofits are hesitant to be adversarial with government for fear of jeopardizing their tax-exempt status, losing donor support or being perceived as too polarizing, “political” or partisan. Instead, these groups may seek to maintain a more neutral position when it comes to policy or social change, particularly when a topic is deemed controversial, such as racism, sexism, homophobia, income inequality, climate change, immigration, LGBTQ rights and others.
Some nonprofit activists and scholars are calling for the nonprofit and philanthropic sector to be more willing to stand together in an effort to dismantle the historical systems that are responsible for bias, discrimination and inequality. Others have called for the nonprofit sector itself to “do better” in creating just and equitable organizations. Read one or both of the articles found at the links in this paragraph and think about the following questions:
• What are the risks to nonprofit organizations if they appear “too political” to some of their supporters? What are the benefits of appearing to stay neutral in policy battles?
• Should nonprofits consider donor wishes when thinking about advocating on behalf of their beneficiaries? How should managers balance the wishes of their different stakeholders?
• Should nonprofits, regardless of their mission, be involved in social or policy change? What if they only have limited resources to do so? Should they move money away from services to advocacy? Why or why not?
1. Kelly LeRoux and Mary K Feeney, Nonprofit Organizations an Civil Society in the United States (New York: Routledge, 2015).
2. LeRoux and Feeney. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.07%3A_Social_Movements_and_Advocacy.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Define how various scholars conceptualize social enterprises.
• Recognize the relative strengths and weaknesses of social enterprises in creating social value.
• Consider the role of social enterprises in a global context.
Chapter Introduction
Social enterprises are a unique form of organization that have captured the imagination of scholars, nonprofit practitioners and entrepreneurs over the last few decades. Yet, they can be hard to define because they mix elements from the nonprofit and business sectors. In this chapter, we will attempt to develop a working definition of social enterprises and discuss their relative strengths and weaknesses compared to other forms of social value creation.
What are Social Enterprises?
Like so many other terms, social enterprises defy an easy definition. One reason is because a social enterprise can be any type of organization and can include a variety of different types of activities. One definition would be “the use of nongovernmental, market-based approaches to address social issues.”[1]
It’s important to note that social enterprises can be for-profit, nonprofit or even public organizations. Although each of these forms may have different ways to generate revenue (grants for nonprofits versus investors for businesses), and would include different forms of organizational governance and accountability, what distinguishes them as enterprises is that they use market mechanisms for social good.
Because of this blending and blurring of for-profit and nonprofit organizations in structure, organizational form and vision, social enterprises are often considered to be hybrid organizations.[2]
Activity 1
Take a few moments to review the two social enterprises below.
Homeboy Industries, based in Los Angeles, has a mission to provide “hope, training, and support to formerly gang-involved and previously incarcerated people, allowing them to redirect their lives and become contributing members of our community.”
BioLite is a “social enterprise that develops, manufactures, and distributes advanced clean energy technologies to off-grid households around the world.”
Discussion Questions:
• One is a for-profit and one is a non-profit. How can you tell? Does it matter?
• Based on the below table in this chapter, how would you categorize their activities? What type of social enterprise is each organization?
What is Social Entrepreneurship?
The study of entrepreneurship in the United States dates back to the beginning of the study of businesses – the early 20th century. An entrepreneur is someone who “combines existing resources in new and interesting ways.”[3] Entrepreneurs are often founders of their own businesses, and as such, assume all the risks and rewards that may come with that. Entrepreneurship is also often linked to the introduction of new products and services.[4]
Social entrepreneurs, on the other hand, are similar in many ways to traditional business entrepreneurs. However, their goal is to create social value as well as, or instead of, profit.[5] Social value is a contribution to the welfare or well-being of society.[6] Their motive may be not only to make money for themselves or their investors, but also to do good.
Social enterprises can be defined as an activity of the social entrepreneur, as they design and develop a nonprofit or business venture that will benefit others.
Activities of Social Enterprises
Like nonprofit organizations, social enterprises are often involved in a variety of activities.
• Commercial activities: Many social enterprises sell goods and services to help fund their social mission. For example, for every pair of socks that Bombas sells, they contribute one pair of socks to unhoused individuals. Hot Bread Kitchen, on the other hand, helps train immigrant women to bake and sell bread, a profession most often held by men in the United States and Europe, but women elsewhere in the world. Yet, this definition of buying and selling goods and services can also be broadly defined and even include more “traditional” types of nonprofits like Goodwill or the Salvation Army.
• Corporate philanthropy: For-profit businesses may engage in activities that help advance social missions. Probably one of the best examples is Ben and Jerry’s Ice Cream and their Foundation, which takes a proportion of their profits and redistributes it to the community in the form of grants.
• Microfinance: Related to commercial activities, microfinance organizations are unique in that they provide financial services (most often loans) to individuals living in poverty around the world. These loans, sometimes just a few dollars, are provided with the goal to help lift a person out of poverty. Groups like Grameen Bank and Kiva are examples of microfinance organizations.
Perhaps another way to think about how to categorize social enterprises is by how they raise money compared to how they distribute money to the community.
In the table below, enterprises have been broken into categories based on “who pays” and “who benefits” from the social mission of the organization.
Model Examples of Enterprises
Customer is the beneficiary Grameen Bank, Kiva
Customer pays for the beneficiary (aka cross-subsidy) TOMS Shoes, Warby Parker, Ben & Jerry’s
Customer buys from the company employing beneficiary Homeboy Industries, Hot Bread Kitchen
Customer buys from company supplied by beneficiary Fair Trade Coffee
Adapted from Ebrahim et al. [7]
Ultimately, social mission organizations can be conceptualized as any form of organization (nonprofit, business or government) that seeks to create social value or meet social needs or problems.[8]
Social Enterprises vs. Corporate Social Responsibility
You may have read the above section wondering what the difference is between social enterprises and companies that engage in a corporate social responsibility (CSR) program, such as promoting a living wage, changing products to be more environmentally friendly or providing grants to the community. The past several decades have also seen a rise in CSR efforts to meet societal expectations and demands about ethical corporate behavior and greater social responsibility.[9] So what is the difference?
While traditional corporations engaging in corporate social responsibility still have profit maximization and shareholder value at their core, many social enterprises have simultaneous goals of profit and increased social value. Although this line can sometimes be blurred, one of the main ways that these ventures differentiate themselves as social enterprises is through new organizational forms like benefit corporations, which we discuss in the next section.
Benefit Corporations and “B-Corps”
Looking at traditional business models, some entrepreneurs and business leaders have wanted to do more and form a social enterprise. Some states in the U.S. have started to recognize for-profit social enterprises as distinct from other for-profit businesses – and define them as benefit corporations. (It’s important to note that nonprofit social enterprises are still generally regulated as nonprofits, but may be required to file additional financial filings and even pay some taxes depending on their activities and state and federal law.)
One way that states recognize benefit corporations is by certification through third party organizations like B-Lab (see the box below). To become certified, enterprises go through an organizational audit to ensure that they are meeting the bar for creating “social value.”
B Lab, an international benefit corporation certification organization, is a “nonprofit network transforming the global economy to benefit all people, communities, and the planet.” They are one of a few organizations that can provide benefit corporation certification to businesses.
Watch the video above and explore B-Lab’s website. Then, think about the following questions:
1. How are “B-Corps” different from typical businesses?
2. Are benefit corporations and more traditional corporate social responsibility programs different or the same? Why?
3. What might be some differences between benefit corporations and social enterprises. Are they the same?
The benefits of registering as a benefit corporation include less pressure from investors to maintain high profits at the expense of paying a living wage, protecting the environment, sourcing more sustainable products or giving back to the community. Benefit corporations are also able to promote themselves as having met the certification standards, giving consumers the opportunity to choose a business that is also working to create social good.
Critical Conversation
Social Enterprises are Not Social Justice?
Social enterprises have caught the world’s attention over the past several decades by offering exciting and innovative solutions for change. However, some have argued that social enterprises and entrepreneurships aren’t adequate to lead social change broadly speaking – the kind of systems change in politics and power that is needed to reduce or eliminate social and economic inequality and discrimination or to respond to climate change, just to name two.
Read the article Social Enterprise is Not Social Change by Ganz, Kay and Spicer and discuss the following questions:
• The authors argue that solving social problems requires vigorous public debate and democratic processes. Are social enterprises compatible with that, or do they try to circumvent those institutions?
• Do social enterprises have an obligation to engage in these debates? Or is their obligation to stay focused on their enterprise?
• If not social enterprises, who or what else should advocate for social change?
1. Janelle A. Kerlin, “Social Enterprise in the United States and Europe: Understanding and Learning from the Differences,” Voluntas: International Journal of Voluntary and Nonprofit Organizations 17, no. 3 (September 28, 2006): 247, https://doi.org/10.1007/s11266-006-9016-2.
2. Julie Battilana et al., “In Search of the Hybrid Ideal,” Stanford Social Innovation Review, 2012, https://ssir.org/articles/entry/in_s...e_hybrid_ideal.
3. Joseph A. Schumpeter, The Theory of Economic Development (Cambridge, MA: Harvard University Press, 1934).
4. Rachel Lee Gross, “What Is an Entrepreneur?,” The Balance (blog), December 30, 2021, https://www.thebalance.com/what-is-a...reneur-5187721.
5. Helmut K. Anheier, Nonprofit Organizations: Theory, Management, Policy, 2nd ed. (New York: Routledge, 2014), http://books.google.com/books?hl=en&...fnd&pg=PP1&dq="edition published in the Taylor and Francis e-Library," "purchase your own copy of this or any of Taylor & Francis or" "2005 Helmut K." "known or hereafter invented, including photocopying and" &ots=XwI7vdB88A&sig=SK_snvwMXOI0aEPXu2Kj0Q3O73U.
6. Ana María Peredo and Murdith McLean, “Social Entrepreneurship: A Critical Review of the Concept,” Journal of World Business 41, no. 1 (February 1, 2006): 56–65, https://doi.org/10.1016/j.jwb.2005.10.007.
7. Alnoor Ebrahim, Julie Battilana, and Johanna Mair, “The Governance of Social Enterprises: Mission Drift and Accountability Challenges in Hybrid Organizations,” Research in Organizational Behavior 34 (2014): 81–100, https://doi.org/10.1016/j.riob.2014.09.001.
8. Björn Schmitz, “Social Entrepreneurship, Social Innovation, and Social Mission Organizations: Toward a Conceptualization,” 2015, https://doi.org/10.4135/9781483398082.N4.
9. Suntae Kim and Todd Schifeling, “Good Corp, Bad Corp, and the Rise of B Corps: How Market Incumbents’ Diverse Responses Reinvigorate Challengers,” Administrative Science Quarterly, April 15, 2022, 00018392221091734, https://doi.org/10.1177/00018392221091734. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.08%3A_Social_Enterprises_and_Entrepreneurship.txt |
Learning Objectives
After reading this chapter, you should be able to:
• Understand the scope of the international nonprofit sector.
• Define the roles of international nonprofit/nongovernmental organizations.
• Discuss the unique ethical concerns facing international nonprofits.
Chapter Introduction
Much of this book has been focused on the nonprofit sector in the United States – although much of the content can be applied or adapted to international organizations as well. However, this chapter will look outside the borders of the United States and explore the diversity of nonprofit organizations that are active internationally. Many of these groups are registered in the United States (or another “western” country) as nonprofit organizations, but many others are founded and registered in the countries in which they work.
In an international context, nonprofits are often called NGOs, or nongovernmental organizations, signifying their roles as independent of both the state (government) and market sectors, much like nonprofits in the United States. They can be very large, multi-billion dollar organizations that work across multiple countries or small community-based organizations (CBOs) that work only in a single community or region.
A word on vocabulary:
When discussing the work of nonprofit organizations internationally, it is easy to fall into using language that can perpetuate stereotypes in the “developing world.” I prefer to use the phrase low-income countries to describe nations that struggle with poverty and inequality. There are historical reasons why these countries struggle with economic and political development – reasons that have often been outside their control, including colonialism.
If you’d like to read more about this issue, here is a good source for some background on these terms from the World Bank, as well as a strong argument for updating our vocabulary, published by NPR (National Public Radio).
INGOs Versus NGOs
Similar to nonprofit organizations in the United States, the types of nongovernmental organizations globally are diverse, although internationally many groups work on humanitarian aid, economic development, environmental protection or human rights. International NGOs (INGOs)[1] are groups that work across borders – sometimes by working in more than one country, sometimes because they raise money in one country (such as the United States) and spend that money in another country. One example of an INGO is CARE International, an organization founded after World War II. This group now works in more than a dozen countries around the world providing humanitarian relief, economic development and working towards social justice.
Watch the video of CARE International UK in Mozambique as they assist in the humanitarian response to a hurricane in 2019.
NGOs, on the other hand, are organizations that work, raise money and are headquartered in a single country. Equitable Cambodia is an example of an NGO, based in Cambodia, working for peasants rights and social justice causes.
Although INGOs and NGOs are often used interchangeably to describe nonprofit organizations around the world, it’s worthwhile to distinguish them as either those who work across borders (INGOs) or those that are based and work in a single country (NGOs).
Because the registration of NGOs is different from country to country, it is very difficult to get a handle on how many NGOs and INGOs are active around the world. One recent estimate suggested there are at least 75,000 International NGOs, and on a country-by-country level NGOs can run in the millions. In 2009, it was estimated that India had over three million NGOs, while China has an estimated 460,000 registered NGOs.[2] Tracking employment in the INGO and NGO sector is also difficult, but it’s clear millions of people are actively working as either volunteers or staff for INGOs and NGOs globally.
Theories of International NGOs
Like the nonprofit sector more broadly, NGO and International NGO formation can be defined by the same theories we discussed in Chapter 2. That is, they are impacted by market and government failure, contract failure and voluntary failure. However, in many lower-income countries, the scale of government failure can be more significant than it is in the United States or other wealthier nations, as communities struggle to provide basic needs like clean water, sanitation, schools or hospitals.
Social Origins Theory[3] is another helpful theory to use to compare the nonprofit sectors across countries. This theory suggests that the shape of the nonprofit or NGO sector in each country has been defined by the historical, social, political and legal contexts of that nation. For example, a country that provides a stronger social safety net for its population may offer less of those types of NGOs than a country that has no social safety net whatsoever for its poor population.
What INGOs and NGOs Do
NGOs play a variety of roles in development, humanitarian and social justice work. Lewis[4] describes three primary roles: implementer, catalyst and partner. These terms are not mutually exclusive, and organizations can engage in more than one role at any given time.
• Implementer organizations gather and distribute goods and services to those in need. This covers a wide swath of organizations engaged in humanitarian aid responding to disasters, groups that are contracted by governments to provide particular services or those that grant charitable dollars to other organizations.
• Catalyst organizations seek to bring about social or political change. Change can be focused on helping to empower local communities or bringing about change with government, with businesses or among funders.
• Partner organizations work in collaboration with other organizations, including government or other NGOs. This role recognizes that NGOs are rarely acting in a vacuum.
Above you watched a short video about the work of CARE International UK in responding to a humanitarian crisis. Take a few minutes to reflect on the video and review their website.
• Would you consider CARE to be an implementer, catalyst or partner in the work that they do? Why?
The Management of INGOs
One way to think about the management of INGOs is that “the global is local.” That is, effective NGO managers must recognize the political, social, cultural, technological and economic context in which they are working as well as understand the management skills needed to run an organization. Below is one way to consider the different dimensions of INGO management.
Political Factors (P)ey Question: What aspect of a country’s political and legal environment could be beneficial or detrimental to our mission, strategy and operations?
Economic Factors (E)
Key Questions: What aspects of the economic environment will enable or constrain our work? What micro and macro economic factors do we need to consider?
Socio-Cultural Factors (S)ey Questions: How will the society, its traditions and culture affect our mission, strategy and operations? How is the host country’s socio-cultural landscape different from ours?
Technological Factors (T)
Key Questions: How is the country’s technological environment going to affect our mission, strategy and operations? What innovations are available/unavailable?
Adapted from Aguilar, Francis J. (1967) “Scanning the Business Environment”. Macmillan.
• The political environment – INGO leaders need to be conscious of the different political structures and regimes that are active in the country in which the organization is working. Take, for example, Gaza Sky Geeks in occupied Palestine. This organization does its work to enable STEM education and entrepreneurship in one of the most politically contested areas of the world and has to negotiate with both the Palestinian Authority and the government of Israel. Their work in the region relies upon managing the political context successfully.
• Additionally, INGO managers should pay attention to local politics, as many lower-income countries struggle with political instability that can lead to changes in the country’s leadership, civil unrest or even violence.
• Economic Issues – INGOs need to be conscious of the economy of the country in which they are working. If they are raising money in the U.S., they may need to consider the volatility of exchange rates, the average wage of the country’s population and the cost of operations there. For example, Argentina has struggled with high inflation rates for the past several decades, leaving the U.S. dollar more powerful, but making basic needs much more expensive for the communities that organizations may work with. This may also impact the economic security of the staff you employee in the country.
• Socio-Cultural IssuesDifferent people around the world approach problems differently and have different communication styles, gender norms, religious beliefs, social needs and ideologies. Cultural awareness must also take into account how relationships, networks and trust are manifested among different groups of people. Someone who is not from a particular country may not only experience culture shock, but may also struggle to implement plans and goals that are not seen as relevant or appropriate culturally.
• Technological Issues – Many lower-income countries without a solid infrastructure may struggle to offer their citizens consistent electricity, telephone service or internet access. The population may have little to no access to consumer banking as well. Some INGOs seek to focus on these infrastructure issues.
Activity 1
So You Have an Idea
Looking at the problems facing the world, particularly in low-income countries, it’s easy to think you have struck on an idea that can make a difference. Yet, there are thousands of failed projects scattered around the world. Why does this happen? What can you do to avoid similar pitfalls?
Watch this video and then discuss the following questions:
• Do you think that “aid has failed?”
• What are key lessons that aid and development workers should consider?
• (Feel free to review Engineers Without Borders website: https://www.ewb-usa.org/)
Ethical Considerations of INGOs
INGOs may seem like saviors or heroes, addressing key needs of communities around the world; however, some scholars and practitioners have criticized INGOs for enabling an unequal status quo. Rather than being advocates for changes to political and economic systems that prevent community empowerment and participation, they simply add a salve to deeply rooted inequities and injustices.[5]
It’s important to reflect on some of the more controversial aspects of INGO work around the world. At a minimum, INGO employees, volunteers and donors should recognize these tensions and seek to mitigate the challenges these critiques provide.
• Watch this video for a short primer on this topic: (note this video uses the first world vs. third world language)
Since northern nations generally fund humanitarian and development efforts in the global south, this can lead to tensions around power and control, particularly over decision-making about where and how the money is spent. Some leaders may resent foreign intervention in their country. As one southern NGO leader stated, “We have come to regard western NGOs as ‘international’ and the rest of the world as ‘local’. When so-called ‘northern NGOs’ engage with ‘southern actors’ it’s rarely a partnership, it’s more of a sub-contract.”[7]
• Lack of cultural competency – Until relatively recently, many INGOs were staffed by Americans, Europeans or others from higher-income countries. This not only created power imbalances, but also led to organizations employing staff that had very little cultural or practical expertise in the country they were working in. This has started to shift over the past two decades with an increasing number of INGOs hiring most of their international staff from the countries where the organization is working.[8] Some organizations are even starting to move their global headquarters to southern cities, such as Oxfam International’s recent move to Nairobi.[9] The benefit of this approach is to help organizations offer solutions more attuned to local needs. However, diversification can lead to new challenges, including cultural and language barriers between “northern” and “southern” staff, strategic decision-making in multiple contexts, staff from multiple countries working cross-culturally and inequity regarding pay.
• Paternalism – International NGOs have also been criticized for being paternalistic, believing they know what’s right for the communities they are serving without any feedback or input from the local population. This is related to the idea of white savior complex, which is where a white person, motivated by a sense of superiority, seeks to help or rescue people of color or members of their community.[10] In other words, it’s when a white (or “northern”) person feels that they somehow inherently have the skills, knowledge or expertise to know a better solution to a problem than the people who have been impacted by the problem. While this can be a problem in the nonprofit sector in the U.S., it is exacerbated in the global south when Americans, or other staff members or volunteers, travel to there on behalf of an organization that funds a project. This can lead to significant power imbalances, discrimination and bias in decision-making about the project, which can lead to project failure or even do real harm to the community.
Critical Conversation
International Volunteering
Prior to the Covid-19 pandemic, up to a million Americans travelled abroad every year to volunteer with International NGOs, faith-based groups and local communities. This type of volunteering is sometimes called voluntourism – as these opportunities often promise authentic cultural exchange within an immersive experience. There are even organizations that will help arrange various voluntourism opportunities for you, for a fee!
Yet, others caution those who may want to travel abroad to volunteer or work. To these scholars, practitioners and community leaders, voluntourists are really the ones benefiting, not the communities being served.
Read this article and watch the below videos. Then, reflect on the provided questions.
Videos:
• Who is really benefiting when you volunteer abroad? What benefits might you gain? What about the community you worked with?
• What do you think of voluntourism as “social currency?”
• How can organizations that work with international volunteers leverage the energy and passion of their visitors to also best serve their communities?
1. Stephen Commins, “INGOs,” in International Encyclopedia of Civil Society, ed. Helmut K. Anheier and Stefan Toepler (New York, NY: Springer US, 2010), 858–64, https://doi.org/10.1007/978-0-387-93996-4_556.
2. David Lewis, Nazneen Kanji, and Nuno S. Themudo, Non-Governmental Organizations and Development, 2nd ed. (London: Routledge, 2020), https://doi.org/10.4324/9780429434518.
3. Lester M. Salamon and Helmut K. Anheier, “Social Origins of Civil Society: Explaining the Nonprofit Sector Cross-Nationally,” Voluntas: International Journal of Voluntary and Nonprofit Organizations 9, no. 3 (1998): 213–48, https://doi.org/10.1023/A:1022058200985.
4. David Lewis, Non-Governmental Organizations, Management and Development (Routledge, 2014).
5. Jennifer Alexander and Kandyce Fernandez, “The Impact of Neoliberalism on Civil Society and Nonprofit Advocacy,” Nonprofit Policy Forum 12, no. 2 (July 1, 2021): 367–94, https://doi.org/10.1515/npf-2020-0016.
6. Darcy Ashman, “Strengthening North-South Partnerships for Sustainable Development,” Nonprofit and Voluntary Sector Quarterly 30, no. 1 (March 1, 2001): 74–98, https://doi.org/10.1177/0899764001301004.
7. Louise Redvers, “NGOs: Bridging the North-South Divide - World | ReliefWeb,” reliefweb, June 8, 2015, https://reliefweb.int/report/world/n...h-south-divide.
8. Donna Bryson, “Diversifying NGO Leadership (SSIR),” 2013, https://ssir.org/articles/entry/dive...ngo_leadership.
9. Sebastian Forsch, “Moving to the Global South: An Analysis of the Relocation of International Ngo Secretariats,” St Antony’s International Review 13, no. 2 (February 28, 2018): 159–86.
10. Murphy, “White Savior Complex Is a Harmful Approach to Providing Help—Here’s Why,” Health, September 20, 2021, https://www.health.com/mind-body/hea...savior-complex. | textbooks/biz/Management/Introduction_to_the_Nonprofit_Sector_(Mason)/1.09%3A_International_Organizations.txt |
Warren Bennis famously wrote in his book On Becoming a Leader that a manager does things right and leaders do the right thing.Bennis (1985). Like other leadership scholars, Bennis makes a clear distinction between leadership and management and between managers and leaders. A manager’s behavior and activities focus on controlling, planning, coordinating, and organizing. This differs from a leader, whose behaviors and tasks focus on innovation, vision, motivation, trust, and change.Bennis (1985).
Table 1.1 Difference Between Management and Leadership. Note. Adapted from Kotter, What Leaders Really Do (1999). Cambridge, MA: Harvard Business Review.
Managers Leaders
Cope with complexity by… Cope with change by…
planning for goals setting direction
budgeting for goals developing a future
establishing agendas and tasks having a strategic vision for change
organizing roles and responsibilities aligning of people
structuring staff and jobs communicating direction
delegating people creating coalitions
monitoring and implementing results being commitment focused
identifying deviations motivating and inspiring
planning and organizing to solve problems leveraging human value and potential
Cultural intelligence requires leadership, not management. It calls for what Ronald Heifetz (Taylor 1999). defines as courageous leadership, that is, the courage to see reality and help others see their realities: the realities of who they are, how they behave, what talents and skill sets they have or are missing in this global world, and what opportunities should be capitalized upon and seized. Leaders must be able to see and anticipate what skill sets are needed in the future, not just develop their employees’ skills for the moment.Goldsmith (2006).
Culturally intelligent leaders must create an environment where diversity and culture flourish, and where conflicting values can be safely expressed and explored through dialogue. Barry Salzberg, CEO of Deloitte, says that organizations and leaders must ask themselves the hard questions: Does our corporate culture really accept the differences it invites, and do we really embrace the different perspectives that come from increasing our commitment to recruiting?Salzberg (2008), p. 123. This type of perspective demands leaders who work toward transformation, or what Couto calls citizen leaders, “transforming leaders who engage others in efforts to reach higher levels of human awareness and relationships.”Couto (1995).
1.02: Importance of Leadership in a Global Economy
Over the years, leadership scholars have found in their studies that, when talking about the leadership process, culture matters.Koopman, Hartog, & Konrad (1999). In general, the leadership literature points to the critical need for cross-cultural and global leadership, especially given the pressing need to build networks and relationshipsGoldsmith, Greenberg, Robertson, & Hu-Chan (2003). and to create an appreciation for differences and similarities. Bennis noted that, although leadership competencies have remained the same, it is “our understanding of what it is and how it works and the ways in which people learn to apply it has shifted.”Bennis (1985), p. 3.
Leadership theories and models available thus far, while helpful in understanding leadership development, are inadequate paradigms for a full understanding of the changing nature of leadership in the 21st century. Goldsmith et al.Goldsmith et al. (2003), p. 7. argued for new forms of leadership that include thinking globally, appreciating cultural diversity, developing technological savvy, building partnerships and alliances, and sharing leadership. Research into cross-cultural leadership revealed that understanding national cultures is critical to leadership development and that organizations must accept differing perceptions of leadership.Derr, Roussillon, & Bournois (2002), p. 298.
Leadership theories and programs that operate from a Western-based, androcentric framework hinder the shift that is required for understanding leadership on a broader level. Situational leadership theories,Northouse (2007), pp. 15–108. which focus on leadership traits, skills, and styles, are inadequate models in this regard because their basic foundation (understanding the individual as leader) implies a Western-based ideology of leadership that does not exist in many national cultures; therefore, the underlying concepts of this style of leadership do not always translate universally. Other theories, such as transformational and team leadership, emphasize the collective voice as essential yet neglect the cultural implications for leadership. Even cultures that share similar Western beliefs about organizational structure still operate differently based on their unique cultural contexts.Mutabazi (2002), p. 204.
In a global economy, it is becoming increasingly more important to understand the wants and needs of those we serve, that is, the internal and external stakeholders. Having awareness of this need means that leaders must be able to shape the culture of their organizations to address changing stakeholder needs. Edgar Schein noted that leaders can do this by having a “personal sense that they are the creation of the cultures of the countries, families, occupations, and reference groups, and that culture plays a huge role in the capacities of their organization to form.”Schein (2006), p. 259. Culturally intelligent leaders need be strategic in aligning the culture of their organizations with the people who work in them. This organizational culture becomes an advantage for leaders, making it easier for them to respond to external environmental factors, which include culture shifts.
Debbe KennedyKennedy (2008), pp. 35–40. proposed the following five qualities that leaders need in order to address and use cultural differences to the advantage of their organization:
• Leaders must make diversity a priority.
• Leaders must get to know people and their differences.
• Leaders must enable rich communication.
• Leaders must make accountability a core value.
• Leaders must be able to establish mutualism as the final arbiter.
These five characteristics I have seen as important differences between the ways that managers and leaders handle cultural conflicts and situations. Culturally intelligent leaders are those that elevate diversity to the top of organizational planning and view it as a critical factor to innovation and creativity. Innovation in diversity begins with a definition of diversity, which many organizations lack or have poorly articulated. If they do, diversity definitions are focused on race and ethnicity and do not explore the dynamic dimensions implicit in culture. In a 2007 study on diversity in the workplace, the Society of Human Resource ManagementHuman resource management guide (n.d.). reported that only 30% of organizations have a shared definition of diversity in the workplace. However, 75% feel that diversity can be used to improve work and relationships. A focus for, and an articulation of, defining diversity and its importance in the work force can open dialogue for organizations.
Having culturally intelligent leaders in organizations matter because they help to develop a curiosity for differences in the workplace in employees. They help to provide access to information and intentionally gather cultural knowledge on a daily basis that will help them and others learn more about differences and the influence of differences in the workplace. Additionally, leaders can foster creativity and curiosity when they set aside some time, on a day-to-day basis, to practice and master their cultural intelligence skills.
When I have seen culturally intelligent leaders in action, they cultivate an environment of trust, which is critical when working with differences in the workplace. Patrick LencioniLencioni (2002). wrote that trust is a critical foundational element in interpersonal relationships. Leaders must be willing to be vulnerable in intercultural interactions, openly admitting what they know and don’t know about culture and cultural differences. They must be able to admit that they might not be able to resolve intercultural differences. By demonstrating vulnerability, a leader enables richer communication and creates an inviting space and environment for intercultural dialogue. In this situation, people are more willing to ask for help and to provide one another with constructive feedback; they take risks and learn to appreciate the differences in skills and style that each person brings to the work environment.
For diversity and culture to flourish in organizations, everyone in the workplace must hold each other accountable toward differences. My experiences working with leaders of different sectors, both formal and informal, have shown me that the creation of a mission and vision for diversity can only take an organization so far. Culturally Intelligent leaders create standards of accountability, explaining what is expected of each employee and of themselves in intercultural interactions.
As an example, I was brought in to facilitate a workshop about cultural differences for public sector employees. In this workshop, the city manager and a city council member were present; they wanted to demonstrate to their employees the importance of culture and their commitment to diversity in the city. At the end of the session, they stood up and addressed the participants, reminding them that the workshop they participated in was only one of many to come. Moreover, the city manager and city council member told the employees that they would do whatever it took to ensure that everyone was held accountable for delivering culturally relevant services to the department’s clients. In this way, “Putting differences to work is greatly enhanced when personal responsibility is a common thread woven tightly into everyone’s fabric.”Kennedy (2008).
When everyone is held accountable for their choices and behaviors in an intercultural workplace, there is a higher level of respect and trust among workers. Everyone is encouraged to perform his or her best and to hold themselves to the highest standards in working with each other. Intercultural conflicts still occur, but the responses to these conflicts from individuals are different.
Lee Bolman and Terrence DealBolman & Deal (2008). wrote that organizations are a coalition of individuals and groups with different interests, preferences, and beliefs. The differences among individuals and groups can change, but this usually occurs very slowly. Leaders must be able to identify mutual interests, values, and beliefs in order to create a culture of mutual interdependence. Because conflict is unavoidable, and often necessary, it is best for leaders to create a picture of mutual dependence that is both beneficial and progressive for employees.
Leadership matters even more when cultures are intertwined in the workplace. Leadership and culture are like two pieces of rope. On their own, they can be used to bundle objects, connect one thing to another, and even support weight. When threaded and intertwined, they do all of these things but are much stronger and have less chances of being snapped. A rope is firm and strong yet flexible and pliable. Because change is constant, leaders can use their cultural intelligence to steer organizations, and those they lead, toward finding innovative strategies and solutions to intercultural issues.
Like an anthropologist, culturally intelligent leaders explore, discover, and find cultural artifacts in their business environment that are both barriers to, and promoters of, growth. A culturally intelligent leader will accomplish this from an “outsider” perspective while keeping his or her “insider” perspective in line. Ronald HeifetzHeifetz (1994). says that one should take a leap to get a balcony perspective when one has been on the dance floor too long; this enables one to see a bigger picture of what is really going on in the intercultural business workplace. Reminding yourself that what you see is only one perspective of a bigger picture can help you to pay attention to what you did not notice or what you cannot see. Cultural intelligence requires leaders to take a critical role in guiding different values in order to bring them into alignment with the business. However, leaders need not do this alone; in fact, they should invite and encourage members to assist in addressing diversity and then challenge them to be culturally intelligent as well.
1.03: Summary
• Culturally intelligent leaders are change-focused and change-ready. They anticipate different scenarios for change and enable their organizations and people to embrace change.
• Many leadership scholars differentiate between management and leadership and managers and leaders.
• Managers are responsible for controlling, coordinating, planning, and organizing. Leaders are people who inspire, motivate, unite people, and create visions for the future.
• Cultural intelligence requires leadership and leaders, not management and managers.
• Historically, leadership theories and frameworks are based on Western ideologies and perspectives.
• Leadership theories and frameworks must incorporate a global perspective that considers differences in perceptions of leadership and leaders.
• Leaders must be able to create cultures where differences thrive. They may accomplish this by: making diversity a priority, getting to know people and their differences, enabling trust, holding each person accountable for differences, and establishing mutual interdependence.
• Leadership and culture are intertwined like two halves of a rope threaded together. At times, leaders must be able to step away from what they are experiencing to understand the full impact of culture on leadership. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/01%3A_Culturally_Intelligent_Leadership_Matters/1.01%3A_The_Difference_between_Managers_and_Leaders.txt |
Imagine a tree as a metaphor for a cultural system—all the things that make up who you are. The roots of a tree are essential for the survival of the tree. They carry the nutrients needed for the growth of the tree and store nutrients for later feeding. Roots of trees are generally located in the top 6 to 24 inches of the ground, not too deep from the surface. The roots are impacted by their surrounding, and environmental factors contribute to their health and vitality.
Just like the roots on a tree, cultural systems have roots that are impacted by their surroundings. A culture’s rituals, traditions, ceremonies, myths, and symbols provide it with the nutrients it needs to survive. Environmental factors can change a tree by uprooting it or letting it die off, making space for new life in its place. Similarly, environmental changes impact cultural systems, forcing it to adapt and change to its surroundings or transition into death, creating new cultural stories that carry new life.
But unlike trees and their roots, we get stuck in our cultural systems and do not budge even when our surroundings have changed. Trees, like anything in an ecosystem, have natural cycles of renewal and rebirth. Sometimes this renewal and rebirth is gradual and gentle, while other times it is fast, disruptive, and violent. Trees, because they share their environments with others, will learn to adapt and allow change to occur, no matter what the direction of change may be. Change in their cultural environments is inevitable and a part of the life cycle.
In similar ways, we can think about our cultural systems as part of a larger system. Some cultural anthropologists would describe the cultural systems as “big C” (macroculture) and “little C” (microculture). The macroculture refers to a larger cultural system, for example, Catholicism is a culture that is not bounded by geography. Within the macroculture of Catholicism are smaller units of culture called subcultures. Change is constant in each cultural system, and transitions, renewal, and rebirth are endless cycles. As cultural shifts occur in the macro- and microcultures, small and large, gradual and disruptive, the entire system learns to adapt in different ways.
2.02: What is Culture
Definitions of culture cover a wide range of perspectives. When I ask participants in my business workshops to describe culture, the following are words and phrases they use: food, religion, language, music, region or geography, ethnicity, clothes, and so on. Generally, there is always one person who raises his or her hand timidly and says, “I think culture is more than that. It’s the things we don’t see, like our beliefs or views about gender.” Both are correct—culture represents the things we see, the tangible, as well as the intangible things.
Figure 2.1 Iceberg Metaphor
The iceberg, a commonly used metaphor to describe culture, is a great example for illustrating the tangible and the intangible. When talking about culture, most people focus on the “tip of the iceberg,” which is considered as making up 10% of the object. The rest of the iceberg, 90% of it, is below the waterline. Most leaders in businesses, when addressing intercultural situations, pick up on the things they see—things on the “tip of the iceberg.” This means that they never address the cultural issues and problems that are underneath the surface level. Solutions become temporary band-aids covering deeply rooted cultural systems.
I once had a manager describe and define culture as “a monster.” After some laughter from the group, he clarified his statement: “It’s so messy and sometimes it’s too big to handle. And, it’s scary because you don’t know what you’re dealing with.” What he said rings true for many people and businesses that work in multicultural settings. It is certainly not fun to clean up cultural messes, bloopers, or misunderstandings, and when not addressed right away, they can result in large cultural conflicts. The ability to acknowledge one’s cultural mistakes, and having a commitment to learning what culture brings, is a skill that one must have in cultural intelligence work.
This definition of culture as a “monster” is one that looks at culture and its manifestations. Some may even say it is negative and does not paint culture in a positive light. From my experiences working with leaders, defining culture is not about positives or negatives—culture just is, and that is why it can be a challenge to describe it. Definitions of culture usually incorporate an expression of values and beliefs of groups, the learning that occurs in groups, and the expressions of those cultural norms.
The following is a definition of culture that is used in this book and that will be useful in your work:This definition of culture has been adapted from Edgar Schein’s definition of culture.
Culture consists of the shared beliefs, values, and assumptions of a group of people who learn from one another and teach to others that their behaviors, attitudes, and perspectives are the correct ways to think, act, and feel.
It is helpful if you can think about culture in the following five ways:
• Culture is learned.
• Culture is shared.
• Culture is dynamic.
• Culture is systemic.
• Culture is symbolic.
Figure 2.2 Elements of Culture
2.03: Culture is Learned
Geert HofstedeHofstede (1991). views culture as consisting of mental programs, calling it softwares of the mind, meaning each person “carries within him or herself patterns of thinking, feeling, and potential acting which were learned throughout their lifetime.”Hofstede (1991), p. 4. Similarly, Peter SengeSenge (1990), pp. 8–9. argued that mental models lock individuals and groups into a specific perception about the world. Like a computer, we are programmed to act or behave in certain ways. The conscious and unconscious learning we undergo, over time, turns into beliefs that we consider to be valid. We then teach each other that these beliefs are cultural norms, and they are then expressed in our daily lives as behaviors and actions.
Think about your first day with your current organization or one you worked for in the past. Typically, your boss or a co-worker gave you an orientation to the company, describing its mission, products, and services. Most likely, you met your co-workers and received a tour of the office facilities. Perhaps you met and talked with co-workers to get a sense of how your job related to their work. Maybe you spent time reading company materials, reviewing your department files, or talking with your supervisor about the details of your job responsibilities. Perhaps you had lunch with other staff members and were told about some parts of the organization such as, “Jane Doe should be fired but is still working here,” “The CEO has control issues,” or “The fax machine breaks down three times a day.” Whatever you did in those first hours or days of orientation and training, you created an image of how you would fit into the company. In that moment, you told yourself a story of how you would work with the company and how it would work with you because others in that business culture told you how you needed to behave. This moment is so powerful that it shapes your experiences, including your thoughts, actions, behaviors, beliefs, and attitudes for the rest of your time with the company. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.01%3A_Cultural_Systems.txt |
Ming is a recent college graduate with a degree in accounting. She has taken a job with a large accounting firm. Although she gets along with members of her department and team, she tends to spend her free time with other colleagues who are of Asian descent, especially those who are in her generation. She feels that this group of coworkers understands her better and shares her values and ideas around work–life balance.
John has been with his state employer for thirty years, working up the ranks into seniority in his state agency. It’s been customary for him and six coworkers of his age group to meet for lunch every day and discuss the latest sporting events. Once a week during the summer they meet up after work to play baseball at a local park and recreation site.
These two examples describe culture as a shared learning experience. Although you may think of yourself as an individual, you share beliefs, rituals, ceremonies, traditions, and assumptions with people who grew up or live in similar cultural backgrounds. It is easier for you to relate to someone who has shared value systems and ways of doing things than someone who does not share the same values.
The patterns of culture bind us together and enable us to get along with each other. Even though it feels good to be around people who think, act, and behave as you, shared learning can create blind spots. Shared cultures create a dynamic of an in-group, where people segregate themselves from each other. Within teams in organizations, in-group blind spots can lead to “group think,” a term coined by Irving JanisJanis (1973), pp. 19–25. to explain the ways in which groups ignore alternative solutions and take on actions and behaviors that discount the experiences for others.
2.05: Culture is Dynamic
Culture is dynamic and thus complex. Culture is fluid rather than static, which means that culture changes all the time, every day, in subtle and tangible ways. Because humans communicate and express their cultural systems in a variety of ways, it can be hard to pinpoint exactly what cultural dynamics are at play. Consider, for example, a conversation about a person’s attitude or feelings. In this type of conversation, Albert MeharbianMeharbian (1971). found that people pay attention to (a) the words, or what is being said; (b) the tone, or how the words are said; and (c) the visual behind the words, often called the body language. All of these are aspects of culture that are interpreted differently depending on the cultural context. Add multiple layers of culture to the conversation—such as time, power and authority, emotion, age, gender, religion, nationality, and even previous intercultural interactions—and communication at a cross-cultural level becomes complex and hard to manage. The following is an example of the dynamism of cultures:
Sheila is the director of marketing for a social services agency. She provides feedback to one of her managers about how to improve services. Sheila sits behind a large executive desk and is leaning forward. The employee sits with her arms crossed, leaning away from Sheila.
If you were observing this scene, are you able to tell from the body language what each person is thinking? Why or why not? What cultural factors might be present?
In the example, Sheila’s body language can be interpreted as any of the following: eager to assist or help, intensely interested in what the employee has to say, aggressive and wanting more information, or needing deeper engagement in the conversation. Her employee’s body language could mean any of the following: protective, suspicious, not caring, or relaxed. To understand the dynamics of culture in this example, you would need to pay attention to the things you do not see such as:
• Is Sheila older or younger than her employee?
• What has been their working relationship?
• Does Sheila naturally lean forward when speaking with her employees?
• What is the tone of voice in the conversation? | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.04%3A_Culture_is_Shared.txt |
In systems theory, systems are interrelated, interconnected parts that create a whole. There are patterns of behavior, deeply rooted structural systems, which are beneath the waterline. What we see at the top of the iceberg are the behaviors; we do not see what contributes to those behaviors. Consider, for example, a white woman walking down a quiet street. She quickly clutches her handbag closer to her body as she passes a black man. Then, when she spots a white man walking toward her, she loosens her hold on the purse.
To address the system, one must be able to address the underlining patterns. These patterns, because they are deeply embedded in the system, will take up significant effort, time, and resources. Changes to the system are slow and gradual; visible changes may not appear until months, or even years, later.
Because most leaders spend their time evaluating and finding solutions to an “event,” they revisit the issues over and over again, with no positive and sustainable results. The following case study illustrates the systemic nature of culture:
Figure 2.3 Culture from a Systems Approach
Langley, Knox, and Cooper, a law firm in the Midwest, knows that it has to do more to be inclusive to women attorneys. It has met challenges in retaining its female work force. The majority of women hired to work at the firm leave within a three year period. To address the issue, the firm provides gender sensitivity training to the entire company, attends graduate career fairs to actively recruit female attorneys, and has quotas for promoting women. However, the efforts in the past five years have yielded little results.
Langley, Knox, and Cooper focus much of their attention on the “events” of the system: women leaving after three years or providing gender sensitivity training. A look at the structural patterns reveals a more complex issue that cannot be solved through training and career fairs. The structural pattern is an insidious belief that women enter the law profession with the same opportunities and access to practicing law as men in the firm. Underlining this belief are more patterns of thought that keep this structural pattern in place. Possible patterns of thought could be:
Figure 2.4 A Systems Approach to Find Structural Patterns in Gender Conflicts
• Other women attorneys don’t have this problem, what’s the big deal here?
• Everyone faces the same challenges in making partner. It’s part of becoming a lawyer.
• We match our junior attorneys with senior attorneys who serve as their mentors. Everyone gets the same level of attention, so I am not sure what all the complaints are about.
• This law firm is different from others. If they don’t like it here, then they can leave.
• We give the women in this firm more time off and flexibility than ever before, yet they still think it’s not enough.
Understanding the thoughts help leaders to recognize that yearly gender sensitivity training would never work. These thought patterns, when combined and supported (intentionally or not), are difficult to unravel. The systemic nature of the problem becomes more complex and chaotic as time goes by and the issues are not addressed.
2.07: Culture is Symbolic
Symbols are both verbal and nonverbal in form within cultural systems, and they have a unique way of linking human beings to each other. Humans create meaning between symbols and what they represent; as a result, different interpretations of a symbol can occur in different cultural contexts. Take, for example, a meeting of senior executives who need to make a decision about a new service. This group of leaders has a team culture that orients itself toward a democratic process: decision making is based on one vote from each member. Now imagine a similar group of leaders with the same task but, this time, the group of leaders is comprised of Native Americans. Leaders who are younger in the group ask their elders for advice. This is an example of how cultural systems differ in their interpretation and expressions of culture. In some cultural systems, voting is not an option. The symbol of a vote has different meanings and interpretations—or simply may not even exist in any practical sense—depending on the cultural background.
2.08: Stereotypes and Generalizations
One of the things that can happen in the context of discussing culture is falling into the stereotypes and generalizations of a cultural group or norm. It is important to recognize the difference and the impact these factors have in cultural interactions. In general, stereotypes are negative statements and interpretations made about a group of people. Stereotypes, whether deemed positive or negative, place people into boxes and categories and limit them to those specific perspectives. A stereotype, such as “Asians are good at math,” does not provide the complete picture someone needs to understand the Asian culture or the differences between Asian cultures. Similarly, just because you meet a 70-year old who does not know how to use current technology, it does not mean that other individuals in that generation do not know how to use it.
By contrast, generalizations of cultures are broad statements based on facts, experiences, examples, or logic. There are two kinds of generalizations, valid and faulty, and it is your role to determine which generalizations have validity behind them. Broad characterization of cultural groups can serve as a framework for cultural interactions. For example, Hispanic societies have a high degree of machismo, or, in Middle Eastern cultures, women have a lesser status than men—these types of generalizations are helpful when engaging with people of those cultures. But in all cultural interactions, culturally intelligent leadership requires you to recognize that generalizations do not apply to everyone within a cultural group. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.06%3A_Culture_is_Systemic.txt |
One of the basic tenets of culture is that it consists of levels and sublevels. It is useful to think about culture in terms of five basic levels: national, regional, organizational, team, and individual. Within each of these levels are tangible and intangible sublevels of culture.
National Culture
A businesswoman from the United States is in Germany for contract negotiations between her employer and a large German bank. The meeting is scheduled for nine o’clock in the morning. When she arrives to the meeting a few minutes before its start time, she is amazed that all her German counterparts are already seated and ready to begin the meeting. A few days later, upon her arrival back to the United States, she remarks to her American colleagues her experience with German culture. In particular, she notes their level of attentiveness to punctuality and planning and says, “I thought we were punctual here in the U.S.! It’s nothing compared to how Germans view punctuality.”
This example illustrates the national differences between two cultures: American and German. National differences refer to the cultural influences of a nation that result in its national characteristics. Although nation-states have regional and political differences, national culture can be viewed as the values held by a majority of the population within the nation. These values are largely unconscious and developed throughout one’s childhood. The values are pushed to a level of consciousness when in contrast to another nation’s cultural values.
Within national cultures, values are generally seen as stable over time. National values, because they reflect the traditions of the nation-state over time, will change slightly from generation to generation, but the overall values will remain the same. For example, a German who comes from a culture of punctuality and travels for business in Italy will notice a national cultural difference in how Italians view time (more leisurely and relaxed) as compared to their own national culture.
Regional Culture
An interesting thing about living in the United States is the regional differences that make each part of the country unique. When I attended college in Boston, I heard the expression “wicked” used quite often. After asking my New England friends what “wicked” meant, I learned that it was used to emphasize a point. If I attended a concert that I really enjoyed, I would say, “That concert was awesome!” New Englanders would say, “That concert was wicked awesome.” After living in the Boston area for 4 years, the word became a part of my vocabulary. When I used the word in conversations with my friends and family members in Minnesota, they did not understand what I meant.
All national cultures consist of regional subcultures that influence the characteristics of one group from another in a nation state. The word “pop” refers to a soft drink in the Midwest, but if you go to the East Coast, it is referred to as “soda.” In other regions of the United States, a soft drink is referred to as “Coke.” The following is an example of regional cultural differences and one way the difference is expressed:
Dianne moves from Texas for a job opportunity in Georgia. She lives in Georgia for 25 years and feels that it is her home state. However, her neighbors and co-workers do not think that she is a Georgian. Even though Dianne thinks she is from the south, she is reminded by others that she is “not a southerner.”
Dianne experiences a regional cultural shift that she did not know existed until her move. Although she considers herself a Georgian, she is constantly reminded that she is not a southerner. At a conscious and unconscious level, her regional cultural experiences will dictate her thoughts about herself and others. She may develop the following assumptions and beliefs as a result of the regional cultural influences:
• I better just tell people that I am from Texas.
• Georgians think that you have to be from certain states to be considered a “southerner.”
• If you are from the south, you must have lineage or roots that directly link you to the south. A “transplant” is not considered a true southerner.
What are regional differences and similarities that you have experienced or have been a part of? The following is a chart to help you identify regional similarities and cultures. In the column labeled “Regional Culture Names,” write down two regions of a nation or country, such as West Coast and New England. Then, for each cultural expression listed, write down the regional similarities and differences you notice about each region you have chosen to identify.
Table 2.1 Exercise to Identify Regional Cultural Differences and Similarities
Regional Culture Names Cultural Expression Regional Differences Regional Similarities
Food
Dress code
Language
Housing
Music
Organizational Culture
When you walk into a Target Store, what do you see? What does it look like? What kinds of items do they sell? What do you see when you walk into a Wal-Mart? What does it look like? What types of people shop at Wal-Mart? Who works there?
Shoppers have different experiences walking into a Target versus a Wal-Mart store because even though they are both retailers, their buildings are different, the types of products they carry vary from each other, the workers wear different clothes, the layout of a Wal-Mart store is very different from the layout of a Target store, and the behaviors expressed by workers in each organization are unique to each retailer. These elements give the organization its distinct culture that separates it from the other.
Organizational culture speaks to the culture that is specific to an organization—the culture that makes it distinctive from competitors and non-competitors. Organizational cultures are often referred to as “corporate cultures” and reflect the beliefs, values, and assumptions of an organization. For example, the culture of one school in a school district can be different than the culture of another school located in the same district simply because of what the people in one school culture adhere and react to.
Team Culture
Lupe oversees a business division that includes sales people, engineers, research, and customer service staff. All teams work in different ways to accomplish their business strategies, but they also have work that is cross functional, relying on each other to get their work completed. At times, Lupe is overwhelmed at the teams’ cultural differences and the impact it has on productivity and sales. She knows that each team has their own working styles, but she didn’t realize how much these styles could interfere in the day to day operations of the division.
The sales department seems more outgoing and energetic than her engineers, who as a whole seem introverted and serious. Her researchers are detailed and scientific in nature, always questioning the tactics of the sales people. Her customer service employees who are by nature people and service friendly and always wanting to make sure everyone gets along. These departments work well, but Lupe knows that silos in the organization can hinder growth and creativity.
The example above illustrates culture at the team level. The values, beliefs, and norms of culture are present in team environments, dictating the team’s operations and efficiency. Cultural norms in teams guide members in their dress and appearance, their language, how they relate to one another, and how they get along. Some teams are very serious, while others use humor in their work life. Departments, teams, or workgroups can, and will, act very differently from each other even though they are located in the same building and in the same organization. Although you might not think about personality or temperament as cultural elements, they can and do shape a team’s culture.
Individual Culture
Individual cultural differences relate to your preferences for things through your personal experiences that include the influence of your family, your peers, school, media, co-workers, and so on. You may share a national culture, such as being an American, with another person and live in the same regional culture, the Midwest. You may even work with the person in the same organization and department, thus sharing an organizational and team culture, and even though you share similar interests, you will likely have differences in individual culture based on who you are and your social upbringing. The following example illustrates these individual differences:
Bao, 31 years old and Hua, 32 years old, are both Chinese American managers living in San Francisco. They both grew up in the area as third generation Chinese Americans. Both attended universities on the East Coast in the same city and majored in public policy. Bao and Hua work for a national nonprofit that funds grassroots leadership projects in Chinese-American communities in the United States. Both work in the programming department of their organization and have been there four years each.
Bao and Hua, although similar in their cultural backgrounds, have different perspectives based on their individual cultures. Bao’s mother passed away while she was very young and she was raised by her father and aunts. Her father was not around because of long work hours. Bao, with the help of her aunts, raised her younger siblings. Her mother’s death was a significant event in her life as she felt she did not have the mother-daughter relationship that many of her peers did. As a result she is overly protective.
Hua is the youngest child in her family. Both her parents are still alive. Hua was raised around many of her relatives who took care of her while her parents were working. She has always been given what she wanted or needed. Whenever Hua had a problem, her older siblings took care of the situation. As a result, Hua is quite relaxed in her demeanor and approach to life.
When Bao and Hua make programming decisions, Bao approaches her decision-making process from a methodical and careful perspective, always looking out for the program’s and organization’s needs. Hua, on the other side, is more relaxed in her approach, more willing to allow for flexibility and ambiguity.
Bao and Hua’s cultural experiences have shaped them into different individuals and have impacted their managerial and leadership styles. Even though they share many similar cultural experiences, their individual cultural experiences have strong influences on them. Bao’s methodical and careful decision-making processes are a result of her having to be responsible at a very early age. Hua’s relaxed approach comes about because of her experiences as the youngest child and always knowing that she would be taken care of—that everything would be okay in the end.
These five levels of culture are important to think about and recognize, but it should also be understood that each of these cultures can be expressed in subcultures or microcultures. Not everyone acts or behaves the same in a national culture such as the United States. There are regional, county, and city differences within the national culture of being an “American.” There are religious differences as well as gender cultures, ability and disability cultures, cultures revolving around sexual orientation, and even cultures centered around concepts or states of being, for example, the culture of homelessness or the culture of juvenile delinquency. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.09%3A_Levels_of_Culture.txt |
Cultures show up in many forms and are expressed differently. Yet all forms and levels of cultures express and share three fundamental aspects: values, assumptions, and symbols.
Values
You need to recognize that value systems are fundamental to understanding how culture expresses itself. Values often serve as principles that guide people in their behaviors and actions. Our values, ideally, should match up with what we say we will do, and our values are most evident in symbolic forms. Consider, for example, a picture of the American flag. If you were an American, what words do the pictures evoke for you? Freedom, liberty, America, united, independence, democracy, or patriotism, perhaps?
What if a Nazi symbol were painted on the American flag? How would that make you feel? Disgusted, sad, angry, revengeful? What would the desecration of the flag symbolize? Hatred, terrorism, nationalism? What about freedom of speech? Symbols like the American flag evoke strong emotions for people, and when the symbol is desecrated, it can feel like a personal attack on the person’s value system and their beliefs about the world. It feels out of alignment from what we believe to be true—what we see as our reality of the world. This is because our values and beliefs are rooted in stories we tell ourselves over and over again.
Joseph CampbellCampbell (1988). noted that stories and myths are our psychological maps of the world. We use them to guide our thinking and behaviors, and when we do not like a story or it does not align with stories we know, we discard them. We learn through culture to create a story about the story. Campbell said that when we can unravel our stories, we begin to see the meaning we have placed on them and the impact they have on our lives. The case study that follows illustrates this notion of values:
James works full-time managing a fast food restaurant chain. Working extra hours every week helps him bring home more income for his family of four. He will do whatever it takes to help take care of his family. Ana is also a manager in the same restaurant. She works her forty hours a week and then goes home to her family of three. She doesn’t want to work more hours because she wants to spend as much time with her family as possible.
How does James’s perspective of family differ from Ana’s? What assumptions does each have about the value of family? What might be the stories they are creating for themselves that shape their values of family? Both individuals have the same value of family, but their values are expressed differently through their behaviors. A value such as family can be expressed and thought of differently from one culture to the next or from one person to the next. James believes that working hard illustrates his value of family, while Ana believes that spending time with her family demonstrates her commitment to the value. These assumptions are not expressed verbally, and, in some cases, the assumptions can be unconscious. Notice how, in the following scenario, James’ assumptions are challenged:
Both Ana and James receive a bonus for their work. James finds out that Ana has received the same percentage of bonus that he has. He’s quite upset because he knows that he works more than she does and sometimes covers her shifts when she has family emergencies or is late because of day care issues. He thinks to himself, “How could she get the same bonus as me? She doesn’t even work that hard and she comes in late to her shift using excuses that her day care didn’t show up again.”
In the case study, the assumptions that James has of Ana (Ana makes excuses; Ana comes in late; or Ana does not work hard) can become a problem and conflict between the two. His assumptions are based on his own definition of family, which could consist of any of the following: be responsible, show up on time, or working hard can bring in more money for the family. His assumptions are challenged when Ana receives the same bonus for a perceived different level of commitment.
As a leader, it is important to understand and identify to employees that most of us share the same values. It is our interpretation and expression of the values that creates the conflict. Many people justify bias and discrimination on the grounds of “values” without realizing that it is not the values themselves but the difference between our expression and interpretation and that of those we come into conflict with.
Assumptions
Our values are supported by our assumptions of our world. They are beliefs or ideas that we believe and hold to be true. They come about through repetition. This repetition becomes a habit we form and leads to habitual patterns of thinking and doing. We do not realize our assumptions because they are ingrained in us at an unconscious level. We are aware of it when we encounter a value or belief that is different from ours, when it makes us feel that we need to stand up for, or validate, our beliefs.
In the iceberg analogy, assumptions are underneath the waterline. They define for us, and give life or meaning to, objects, people, places, and things in our lives. Our assumptions about our world determine how we react emotionally and what actions we need to take. The assumptions about our world views guide our behaviors and shape our attitudes. Consider, for example, the following case study:
Kong grows up in SE Asia and has seen only males in leadership roles. Once he moves to the U.S., he assumes males are the only authority figures. Meanwhile his daughters, Sheng and Lia, who have grown up in the U.S. and were raised with access to education and resources learn that they can be leaders. In their professional work they are seen by their peers as leaders.
One day, at a celebration event that Sheng brings him to, Kong meets a White man who is her supervisor. He tells Kong, “Your daughter is a great leader. She’s really helped us through this transition.” He replies politely, “Thank you.” Later, Kong shares with his wife, Ka, the story. He says, “I don’t know why he thinks Sheng is a leader. Women are not leaders. Only men are leaders.”
Symbols
Anthropologist Clifford GeertzGeertz (1973). believed that culture was a system based on symbols. He said that people use symbols to define their world and express their emotions. As human beings, we all learn, both consciously and unconsciously, starting at a very young age. What we internalize comes through observation, experience, interaction, and what we are taught. We manipulate symbols to create meaning and stories that dictate our behaviors, to organize our lives, and to interact with others. The meanings we attach to symbols are arbitrary. Looking someone in the eye means that you are direct and respectful in some countries, yet, in other cultural systems, looking away is a sign of respect. The meanings we attach to symbols can create a cultural havoc when we meet someone who believes in a different meaning or interpretation; it can give us culture shock. This shock can be disorientating, confusing, or surprising. It can bring on anxiety or nervousness, and, for some, a sense of losing control.
While training senior managers in a leadership program, the issue of the organization’s dress code came up in our conversation about differences. All the managers were in agreement that there was a dress code problem. It seemed to the managers that a couple of the employees were not abiding by the dress code policy. At this mid-size organization, the dress code was business casual, but a couple of the employees (the younger ones to be exact) came into work wearing t-shirts or dresses with thin straps. The managers were all confused as to why the dress code was so hard to follow for these two employees. It was obvious to them that business casual meant looking professional and neat, wearing clothes that were pressed and crisp. No matter how many times the dress code was explained to the staff, these two employees never changed.
In the training, we deconstructed the issue to understand what was really at play. The managers recognized that the dress code of “business casual” could mean several things if not explicitly stated in the policy. In fact, one manager said, “We keep saying that business casual is common sense, but our idea of common sense could be completely different from that employee’s version of common sense.” They also discovered that they did not want to be so explicit as to name every article of clothing that employees could and could not wear. They felt that being explicit would take away the feeling or the symbol that the office was a casual and relaxed environment; having policies that dictated everything that someone could or could not do would symbolize a different type of working environment.
As a result of this conversation, the managers recognized the tangible ways in which symbols are manifested in organizations. They became more mindful of the language and words used. They were more intentional about their behavior, now recognizing that each of their reactions or non-reactions is a symbol. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.10%3A_The_Roots_of_Culture.txt |
The work of Geert Hofstede,Hofstede (2001). while employed at IBM in the late 1960s to early 1970s, still stands as one of the most comprehensive studies of cultural values on leadership in the workplace. From his data collected from over 30 countries and 100,000 individuals, Hofstede created a model of value dimensions that speak to the ways that cultures tend to operate. Although this study is generalized to specific countries, his work on cultural value dimensions is helpful to any business doing global and multicultural work.
According to Hofstede, the five main dimensions are identity, power, gender, uncertainty, and time. You can think about cultural value dimensions on a scale or a continuum, where one aspect of the value lies on one side of the scale and the other extreme lies at the other end of the scale.
Table 2.2 Five Cultural Value Dimensions
Value Dimensions One Extreme Other Extreme
Identity Group Individual
Power Egalitarian Hierarchal
Gender Feminine Masculine
Uncertainty Ambiguity Structure
Time Relationship Task
Cultural value dimensions help you to understand culture and to be able to make sense of culture. These dimensions provide you with a perspective of culture for yourself as well as a perspective of how others perceive their culture. All cultures experience these dimensions of difference in many ways, and different cultures solve these differences in many ways. Becoming aware of these concepts helps you to figure out the experiences you have in relation to your culture. It helps to make that experience less ambiguous and threatening. Cultural value dimensions provide clarity and a starting place for cultural awareness. However, they are often seen as intangible and under the waterline, but once you adapt to the cultural dimensions, you become more comfortable and do not see the cultural difference.
Identity
The value dimension of identity refers to the attention of groups or individuals toward group needs versus individual needs as well as toward individual achievement and interpersonal relationships. On a continuum, you see the identity value dimension expressed as such in Figure 2.5 "Dimension of Identity".
Figure 2.5 Dimension of Identity
On one spectrum, there is an expectation of doing things for the group rather than for oneself. On the other side, achievements and needs are individualized. HofstedeHofstede (2001). found that cultures placing a high value on individualism and a low value on collectivism valued individual rights; cultures placing a high value on collectivism valued relationships and harmony. This orientation, he argued, can have a large affect on managing organizations and people.
For example, in many Latino cultures, the concept of family, la familia, is critical to their cultural history and social systems. La familia is the most important social unit and includes extended family members. Decision making, conflict resolution, and negotiation are based on group needs rather than individual preferences; through paying attention to group and collective needs, harmony and relationships are intact. Alternatively, in individualistic cultures, the need of the individual comes first. U.S. culture teaches this to children at a young age. The following is an example that illustrates the differences between individualist and collectivist cultures:
Mary takes her eight year old, Johnny, to the store to buy ice-cream. She asks him to choose what ice-cream flavor he would like. Over time he learns to tell his mother about his personal likes and dislikes. Every time his mother responds to his decisions with encouragement. Over time he learns that he can and should be able to express himself.
By encouraging her child to make decisions and choices on his own, Mary raises a child that considers his personal needs and wants. If Johnny was in a group that operated more collectively, he might become quite upset when told that the whole group must agree to a specific ice cream flavor, that is, that his personal choice does not matter in the group decision.
The following is another example of individual and collective cultures:
A history teacher gives a lesson on the Bill of Rights to her students. She explains that everyone has individual rights and liberties. Sahara is a student in the class. She is thirteen years old and a recent immigrant from Somali. She learns that she has individual rights and to the disappointment and frustration of her parents, her behaviors begin to change at home. She comes home late from school, she stops doing her chores, and she talks back to her mother. She says, “I can do whatever I want. In this country, I am free!”
Sahara comes from a culture that is collective and tribal in nature. Her parents express confusion when they hear her say, “I can do whatever I want.” They do not understand what she means and why she says what she says. They begin to think that she is losing her cultural values.
The following is another example that illustrates the value differences between collectivist and individualist cultures:
Tabitha is 22 years old and moves in with her college boyfriend, Randy, to an apartment near her parents. Tom and Susan, Tabitha’s parents, are excited that she is able to be independent and to live on her own.
Xioli is Tabitha and Randy’s friend from college. She is Chinese American and wants to move out of her parents’ house. Randy and Tabitha have offered the second bedroom space for Xioli in their apartment. Xioli’s parents think she is too young to live on her own. They also think it is a sign of disrespect to them if she, as a single woman, lives with a man.
Power
Hofstede defined power distance dimensions as maintaining strict rules that establish the types of relationships individuals have with one another. Power represents the level of inequality and equality, as well as the level of hierarchy and upward mobility, within a cultural group. In regard to leadership, power dimension can also represent a culture’s tendencies toward authority, on one end, and one’s orientation toward laissez-faire leadership, on the other. Hofstede found that low-power-distance cultures emphasized equality and minimized power and status. The following is an example of this:
Susan is the president of a large manufacturing business. Although she is in a position of leadership and authority, she takes a “hands off management approach” to her employees, and in meetings provides a participatory, democratic engagement process.
Susan’s dimension of power is illustrated in Figure 2.6 "Power Value Dimension".
Figure 2.6 Power Value Dimension
Gender
HofstedeHofstede (2001). describes the value dimension of gender as representing two paradigms of thinking and practice about the world in relation to traditional values associated with gender roles. Gender refers to the culture’s tendencies or orientation toward enforcing or reinforcing masculine and feminine roles in work. Masculine cultures tend to emphasize ambition, control, competition, assertiveness, and achievement, whereas feminine cultures emphasize nurture, care, sharing, quality of life, and relationships. Sometimes these values are expressed as the “quantity of life” and the “quality of life.”
In his findings, Hofstede indicated that cultures that rate high in masculinity, such as Japan, Austria, Venezuela, and Italy, revealed a high proportion of males in dominant structures; in low masculine cultures, such as Denmark, Norway, Netherlands, and Sweden, women were treated more equally in their social systems.
It is important that you recognize that these values are not associated with being male or female. In other words, this does not mean that men cannot be part of feminine cultures or that women do not orient themselves toward “masculine” cultural values. Finally, like other value dimensions, gender dimensions can vary greatly within any culture.
You can think about the value dimension of gender in the ways displayed in Figure 2.7 "Gender Dimensions".
Figure 2.7 Gender Dimensions
Uncertainty
The dimension of uncertainty emphasizes cultures that are either oriented toward uncertainty or toward creating certainty and stability. Hofstede described this as a society’s tolerance for ambiguity.Hofstede (2001). Societies that are in high uncertainty avoidance are rule-bound and pay more attention to written procedures, rules, or goals. Individuals who have a higher need for formalized structures, procedures, or diplomacy tend to minimize their uncertainty levels in order to cope with the unknowns of their situations. Someone who is on the other extreme of the dimension is more relaxed about the rules and procedures; they are more flexible in their attitudes toward rules and policies. The value dimension can be expressed in the ways shown in Figure 2.8 "Uncertainty Value Dimension".
Figure 2.8 Uncertainty Value Dimension
This dimension also speaks to a culture’s orientation toward directness and honesty. Edward HallHall (1981). popularized the terms “high-text” culture and “low-text” culture to describe cultural differences between two different types of societies. The ideas are often used to describe the ways in which cultures communicate and to understand what cultural constructs underlie the communication.
High-context cultures are societies in which people often make inferences; they leave things unsaid, knowing that the other person would understand what was implied in the communication. People in these societies tend to rely on groups for support. Low-context cultures are societies that are explicit and direct in their communication. They generally are more comfortable relying on themselves, as individuals, and working out solutions to problems. Like high-context cultures, relationships are important to low-context societies; the difference is in the longevity of the relationships. Generally, low-context societies have many relationships that are less intimate and close than those of high-context cultures.
Both types of cultural differentiations are illustrated in Table 2.3 "High and Low Context Culture Descriptors".
Table 2.3 High and Low Context Culture Descriptors
Cultural Context Countries/Cultures Descriptors How They Perceive the Other Context
High context Spain
• Less verbally explicit communication
• Implied meanings
• Long-term relationships
• Decisions and activities focus around personal, face-to-face relationships
Low-context cultures are…
• relationship-avoidant
• too aggressive
• focused too much on tasks and goals
Mexico
Greece
Middle East
China
Japan
Korean
Thailand
Low context United States
• Rule-oriented
• Knowledge is public and accessible
• Short-term relationships
• Task-centered
High-context cultures…
• are too ambiguous
• are quiet and modest
• ask a lot of questions
Germany
Great Britain
Australia
Time
The dimension of time speaks to how communities are oriented toward space and time, including their tendencies toward traditions and the past, and their orientation toward the future and the present. In many cultural systems, holding on to traditions is important in current day-to-day operations and relationships. Some societies will refer to traditions to preserve and maintain cultural norms, that is, to protect what currently exists.
Time is also a reference to a culture’s orientation toward tasks or relationships. For example, a manager from the United States who travels to India to negotiate a business contract needs to know that meetings will occur whenever people show up to the meeting, which could be hours after it is scheduled. A task-oriented leader is certain to be frustrated when he meets up with an Indian who is more time-oriented toward relationships. In the American perspective, promptness is professionalism; yet, in the other perspective, the concept of time is more loose and flexible. The value of time is illustrated in Figure 2.9 "Time Value Dimension".
Figure 2.9 Time Value Dimension
Understanding these five value dimensions and their impact in different cultural systems will be helpful to your work in cultural intelligence. Like any cultural model, you need to recognize that cultural factors in leadership and organizations, as indicated by Taylor Cox, differ “across gender, nationality, and racial/ethnic groups as it relates to time and space orientation, leadership style orientations, individualism versus collectivism, competitive versus cooperative behavior, locus of control, and communication styles.”Cox (1994), p. 108. You must recognize that microcultures exist within macrocultures; this is significant in working effectively on a cross-cultural level.Cox (1994), p. 106. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.11%3A_Value_Dimensions_of_Culture.txt |
What is the importance of understanding cultural value dimensions in businesses? Like other cultural systems, organizational culture controls the behavior, values, assumptions, and beliefs of organizational members. It is a combination of organizational members’ own beliefs and the values, beliefs, and assumptions of the organization. It is the role of the organizational leader, as a change agent, to help create a positive organizational culture that meets the demands of a competitive environment, board and shareholder expectations, and employee career satisfaction.
Since the mid-1990s, the Global Leadership and Organizational Behavior Effectiveness (GLOBE)House, Hanges, Javidan, Dorfman, & Gupta (Eds.) (2004). research of 62 societies has served as a significant study for understanding how cultural value dimensions are expressed in different cultures—whether societal or organizational. Knowledge and awareness of cultural values can enable leaders and managers to effectively manage and work through intercultural conflict and interactions. Over 17,000 managers from 951 organizations in 62 societies participated in focus groups, questionnaires, and interviews for this study.
Cultural Value Dimensions
The GLOBE study found that nine core dimensions of cultures exist in different societies. The first six dimensions in the chart below originated from the cultural value dimensions Geert Hofstede proposed in the 1980s. Table 2.4 "Cultural Dimensions as Researched in the GLOBE Study" lists other dimensions, as well as their definitions, as described in the GLOBE study.House & Javidan (2004), pp. 11–13.
Based on the responses generated by the study and using other research, the GLOBE researchers grouped societies into regional clusters. The clusters were a way of creating meaning around societal views of culture and leadership. Each cluster had characteristics specific to their region, language, religion, history, and shared cultural understanding. Table 2.5 "GLOBE Clusters of Societies" and Table 2.6 "Clusters of Societies and their Cultural Value Dimensions" lists each cluster and the countries that were grouped into the clusters.
Leadership Behaviors and Culture
The findings of the GLOBE study served to help organizations and societies understand what made an effective or ineffective leader. Many leadership behaviors are similar across societies, pointing out that no matter the cultural difference or society in which a leader is from, there are specific leadership behaviors that are viewed as effective. The GLOBE project was significant in indicating how cultures perceive effective and ineffective leadership, which is helpful to leaders in facilitating intercultural interactions.
The study revealed six global leadership behaviors, which were used in the study to understand how the clusters perceived leadership. These six are charismatic/value-based, team-oriented, participative, humane-oriented, autonomous, and self-protective. Using their understanding of leadership behaviors and perceptions of leadership from each cluster group, the researchers were able to identify a leadership profile for each cluster. Table 2.7 "GLOBE Study of Key Leadership Behaviors" and Table 2.8 "Leadership Behavior Profiles for Clusters" list the six leadership behaviors and their characteristics as well as the leadership profile for each cluster.
Table 2.4 Cultural Dimensions as Researched in the GLOBE Study
Globe Dimension One Extreme Other Extreme
Uncertainty avoidance Need for established social norms, rituals, and practices Comfortable with ambiguity and predictability
Power distance Egalitarian and nonhierarchal Hierarchy, authority, disparity in status and wealth
Institutional collectivism Collective actions and sharing of resources encouraged Individual actions and goals are encouraged
In-group collectivism Expressions of pride, loyalty, and cohesion Noncohesiveness, loyal to oneself and one’s needs
Gender egalitarianism Nurture, care, relationships, sharing Ambition, assertiveness, control
Assertiveness Assertive, confrontational, and aggressive in social relationships Timid, submissive, and tender in social relationships
Future orientation Planning, investing, and delays of individual or collective gratification Spontaneity, enjoying the present
Performance orientation Encourages and rewards group performance and excellence No rewards and encouragement for goals; more relaxed in terms of achievement
Humane orientation Encourages and rewards individuals for being fair, altruistic, friendly, generous, caring Concerns for self, not sensitive, not encouraging of social supports and community values
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage.
The study also highlighted the perceptions of cultures related to universally desirable and undesirable attributes in leaders. The desirable attributes were viewed as characteristics that were valued and that facilitated the leadership processes. Undesirable attributes were viewed as obstacles and challenges to effective leadership. Table 2.9 "List of Desirable and Undesirable Leadership Attributes from the GLOBE Research" illustrates the positive and negative attributes of effective leadership.
Table 2.5 GLOBE Clusters of Societies
Cluster Countries
Anglo Canada, United States, Australia, Ireland, England, South Africa (White sample), New Zealand
Confucian Asia Singapore, Hong Kong, Taiwan, China, South Korea, Japan
Eastern Europe Greece, Hungary, Albania, Slovenia, Poland, Russia, Georgia, Kazakhstan
Germanic Europe Austria, The Netherlands, Switzerland, Germany-East, Germany-West
Latin America Ecuador, El Salvador, Colombia, Bolivia, Brazil, Guatemala, Argentina, Costa Rica, Venezuela, Mexico
Latin Europe Israel, Italy, Switzerland (French-speaking), Spain, Portugal, France
Middle East Turkey, Kuwait, Egypt, Morocco, Qatar
Nordic Europe Denmark, Finland, Sweden
Southern Asia Philippines, Indonesia, Malaysia, India, Thailand, Iran
Sub-Saharan Africa Zimbabwe, Namibia, Zambia, Nigeria, South Africa (Black sample)
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage
Table 2.6 Clusters of Societies and their Cultural Value Dimensions
Cultural Dimension High-Score Cluster Low-Score Cluster
Uncertainty avoidance Germanic Europe Eastern Europe, Latin America
Nordic Europe Middle East
Power/hierarchy No Clusters Nordic Europe
Institutional collectivism Nordic Europe Germanic Europe, Latin America
Confucian Asia Latin Europe
In-Group collectivism Confucian Asian, Eastern Europe Anglo, Germanic Europe
Latin America, Middle East Southern Asia Nordic Europe
Gender Eastern Europe Middle East
Nordic Europe
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage
Table 2.7 GLOBE Study of Key Leadership Behaviors
Dimension Behaviors
Charismatic/value-based leadership Inspires others, motivates, expect high performance; visionary, self-sacrificing, trustworthy, decisive
Team-oriented leadership Team-building, common purpose, collaborative, integrative, diplomatic, not malevolent
Participative leadership Participative and not autocratic; inclusive of others
Humane-oriented leadership Supportive, considerate, compassionate and generous; modesty and sensitivity
Autonomous leadership Independent and individualistic; autonomous and unique
Self-protective leadership Ensures the safety and security of the leader and the group; self-centered, status conscious, face-saving, conflict-inducing
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage
Business leaders have tremendous power to change the organizational culture by utilizing several methods that address the underlying assumptions, beliefs, and values of its members; however, this is not an easy task. Culture, as explained, is oftentimes manifest in unconscious behaviors, values, and assumptions that develop over time and change as new employees enter an organization. The significance of the GLOBE study is that it helps leaders to understand the role of culture in leadership. By understanding one’s culture, as well as that of others, it brings you to awareness of different perceptions of leadership and how cultures come to understand leaders. Recognizing the elements in leadership and culture enables you to leverage the differences that cultures create and to use that to create positive intercultural growth.
Table 2.8 Leadership Behavior Profiles for Clusters
Cluster 1st 2nd 3rd 4th 5th 6th
Eastern Europe Autonomous Self-protective Charismatic Team Oriented Humane Participative
Latin America Charismatic Team Self-protective Participative Humane Autonomous
Latin Europe Charismatic Team Participative Self-protective Humane Autonomous
Confucian Asia Self-protective Team Humane Charismatic Autonomous Participative
Nordic Europe Charismatic Participative Team Autonomous Humane Self-protective
Anglo Charismatic Participative Humane Team Autonomous Self-protective
Sub-Sahara Africa Humane Charismatic Team Participative Self-protective Autonomous
Southern Asia Self-protective Charismatic Humane Team Autonomous Participative
Germanic Europe Autonomous Charismatic Participative Humane Team Self-protective
Middle East Self-protective Humane Autonomous Charismatic Team Participative
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage
Table 2.9 List of Desirable and Undesirable Leadership Attributes from the GLOBE Research
Desirable Leadership Attributes Undesirable Leadership Attributes
Trustworthy Loner
Just Asocial
Honest Noncooperative
Foresight Irritable
Plans ahead Nonexplicit
Encouraging Egocentric
Positive Ruthless
Dynamic Dictatorial
Motivational
Builds confidence
Intelligent
Dependable
Team builder
Communicator
Adapted from House et al. (2002) The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage
2.13: Summary
• Culture is comprised of both tangible and intangible things you see, hear, feel, and perceive. It consists of the shared beliefs, values, and assumptions of a group of people who learn from one another and teach to others that their behaviors, attitudes, and perspectives are the correct ways to think, act, and feel.
• Culture is a process of learning and sharing, and it is dynamic and symbolic.
• Cultural issues are systemic and understanding this helps leaders to appreciate culture in its fullest sense.
• Awareness helps to eliminate the stereotypes that are derived from cultural misunderstandings, which limit the positive ways in which culture is viewed. However, generalizations about cultures can help serve as a framework for interacting with unfamiliar cultural systems.
• Culture is multidimensional, consisting of multiple layers. There are five main levels—national, regional, organizational, team, and individual—that are most useful in cultural contexts.
• Each cultural layer, when peeled apart, reveals the “roots” of culture, which consist of the values, assumptions, and symbols of the culture. These three ground cultural systems, often making it hard for cultural shifts to occur.
• Familiarity with Hofstede’s model of value dimensions (identity, power, gender, uncertainty, and time) in the workplace helps leaders to realize the impact of values and beliefs in cultural settings.
• The GLOBE study of 62 societies is the most comprehensive research, to date, that analyzes how leadership is perceived by cultures.
• Nine cultural value dimensions, including the five proposed by Hofstede in the 1980s, illustrate the importance of understanding value dimensions in the context of leading.
• There are six global leadership categories that emerged from the GLOBE data: charismatic, team-oriented, participative, humane-oriented, autonomous, and self-protective.
• The GLOBE data points to universally positive and undesirable attributes of leaders. All cultures agree that the following are negative attributes: a leader who is a loner, irritable, ruthless, asocial, nonexplicit, dictatorial, noncooperative, and egocentric.
• Leaders have a role in creating business cultures that make employees feel valued and included regardless of their cultural backgrounds. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/02%3A_Understanding_Culture/2.12%3A_Culture_and_Leadership.txt |
At the core of it, cultural intelligence is your ability to successfully adapt to unfamiliar cultural settings. Peter Earley and Elaine Mosakowski defined cultural intelligence (CI) as the ability to “tease out of a person’s or group’s behavior those features that would be true of all people and all groups, those peculiar to this person or this group, and those that are neither universal nor idiosyncratic.”Earley & Mosakowski (2004), p. 140. Earley et al. wrote that cultural intelligence is not just about learning new cultural situations; it is creating “a new framework for understanding what he or she experiences and sees.”Earley, Ang, & Tan (2006), p. 6. Similarly, David Thomas and Kerr Inkson indicated that cultural intelligence is about
being skilled and flexible about understanding a culture, learning more about it from your on-going interactions with it, and gradually reshaping your thinking to be more sympathetic to the culture and your behaviors to be more skilled and appropriate when interacting with others from the culture.Thomas & Inkson, (2003), p. 14.
The idea of cultural intelligence is an immensely useful tool in business. It helps to bring attention to the differences in thought and behaviors due to cultural factors. Consistently practicing cultural intelligence has been known to increase the success of multicultural team performance. Leaders who are culturally intelligent have awareness of how culture contributes to communication and creates shared learning.Darlington (1996), p. 53.
Tuning into Cultural Intelligence
On a business trip to Texas, my colleague, who had never visited the state, was surprised at the amount of “Spanish music” on the radio. Every time she found a music station or station providing information, the speakers and singers spoke in Spanish. She said, “I can’t find any music that I can understand,” and quickly changed to a local station that played top 40 and pop music.
When I suggested that we should try listening to different music and experience the cultural shift between our state and another, she said, “No way. I can’t understand what they’re saying!” I replied, “I can’t either, but it’s a part of the culture here and wouldn’t it be interesting to be like one of the locals?” Her response, “That’s okay. I’ll just stick to what I know.”
Cultural intelligence is like tuning into different stations, being able to adapt to one’s new environment, and, in this case, to the style of music in this region of the United States. Like my colleague, we all have particular stations that we like. Music that is familiar provides us with comfort. Tuning in to the same stations over and over again breeds familiarity with the songs and the types of programming broadcast by the stations. We even program the stations into our car radio so as to know exactly what buttons to push if we want to hear a specific music genre.
When you are in a different city or state, you begin to lose the signals of your favorite stations. Try as you might, the stations often do not come through. What might you do? You could find another station in that state that offers the same music or information that you like. Upon finding it, you might program it so as to not lose the station. However, what if the radio frequencies you encounter pick up limited stations? Like my colleague, you might turn off the radio or change the station back to one that is familiar. Or, like her, you could bring your own MP3 player with your own music.
Similarly, when you are in unfamiliar cultural settings, you realize that the signals you are receiving are vastly different from your own. You are not familiar with what your new surroundings are communicating to you. Your first reaction is to find something familiar, and you look for cues and signs to help you adjust. However, you cannot always rely on what you know and what you can bring with you. Like my co-worker, bringing equipment, like an MP3 player, does not always guarantee successful integration. After many tries, she found out her MP3 player did not work in the rental car; she opted for turning off the radio altogether. In intercultural interactions, the equipment—that is, our skill sets and our knowledge—may not be enough to cope in a new cultural environment. We need to be able to learn how to turn off or reset ourselves to better adapt to the new situation. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/03%3A_Cultural_Intelligence_Defined/3.01%3A_What_is_Cultural_Intelligence.txt |
Cultural intelligence is a framework to help you learn to turn off your “cruise control.” Like a computer that has been on too long, is working too hard, or has too many programs running that cause it to freeze, we have to learn to reset our mental programming. Sometimes, resetting it once or twice does not work; you will need to turn it off completely by taking a pause and then returning to it at a later time.
Cultural intelligence emphasizes three areas: metacognition and cognition, motivation, and behavior. Metacognition and cognition represent your ability to think, learn, and strategize. In CI, the principle of motivation refers to your self-efficacy and confidence, your ability to be persistent, and the alignment to your personal values. Behavior, in CI, is about your ability to have a repertoire of skills and your ability to adapt your behavior.
The framework for cultural intelligence consists of the following parts: knowledge, strategic thinking, motivation, and behaviors. It may be helpful to think about these as the ABCs of CI: Acquire, Build, Contemplate, and Do.
Figure 3.1 Cultural Intelligence Model
Acquire Knowledge
A fundamental piece of inter- and cross-cultural interactions is the knowledge a leader has when working with cultures unfamiliar and different from his or her own. Knowledge is a central tenet in intercultural training and is included in the cultural intelligence model because it is essential for any person, whether leading or managing, to be attentive to cultural systems. You must know how cultures are created, interpreted, and shared, as well as how cultural interpretations, meaning, and symbols can impact behaviors and attitudes.
You can think about this aspect of the model as acquire, because you need to acquire information and knowledge that help you to identify cultural elements at play. The acquisition of knowledge—tapping into what you have stored in your memory—is cognition.
Build Your Strategic Thinking
Once you gain knowledge about the culture, how will you use it? What parts of the knowledge obtained will you use? Will they all fit, given the cultural setting? These questions address the component of cultural intelligence that speaks to your ability, as a leader, to strategize across cultures. It is your ability to build awareness of your surrounding through preparation and planning. It is often referred to as “metacognition.”
Earley et al. noted, “Figuring out how things operate and what is appropriate in a new culture is detective work using the facts of the case—assemble them, order and organize them, interpret them, act on them.”Earley et al. (2006), p. 27. Strategic thinking is important because it is how you think about, or make sense of, the knowledge and use it in a way that helps you better perform and interact with different cultures. If you are able to understand how you learn the information and how you have processed it, this helps you to make sense of unfamiliar situations. Early and PetersonEarley & Peterson (2004), p. 105. wrote that when there is a focus on metacognition, this component of CI can help people to develop and expand their behavioral repertoires.
Contemplate Your Motivation and Ability to Work with Others
The third element of the cultural intelligence model speaks to your ability to pay attention to your surroundings as well as your responses to unfamiliar situations. It is about reflecting upon your own interests, your drive, and your motivation, as well as your willingness to work through, and with, cultural interactions.
You can think about this component of the model as contemplate because it requires you to be present—to take a step back, suspend your judgments and biases, reflect upon your assumptions, and listen carefully. It requires that you be alert and remain aware of your cultural surroundings. As a leader, presence allows you to identify the cultural scripts that are hidden and to recognize when to turn them off.
Adapt and Perform
Richard Carlson said that “everything we do has the potential to influence another human being…the key element here is not to second-guess yourself but rather to become conscious of how your life choices influence those around you.”Carlson (2005), p. 130. Carlson speaks to our level of conscious choice in day-to-day living. When do we choose to adapt to our environments? Because of a choice we made, what did we let go? How has our choice affected our beliefs and values?
These questions address the fourth component of cultural intelligence, which is your adaptability and ability to perform new behaviors based on new cultural surroundings. Are you aware of how others see you and how you come across to them? How do you interpret what others say, and how do you respond? Culturally intelligent leaders are like chameleons in social environments, changing their behaviors to mimic their surroundings. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/03%3A_Cultural_Intelligence_Defined/3.02%3A_Cultural_Intelligence_Model.txt |
Howard GardnerGardner (1983). popularized the idea that intelligence is more than cognitive capacity—that human potential cannot be limited to cognitive intelligence the way it is described and defined in society. You can think about cultural intelligence as another form of intelligence. People with this particular intelligence have the ability to steer their way through unfamiliar cultural interactions; they do this in what seems to others as an effortless manner. This does not mean that culturally intelligent people are more intelligent overall than others; rather, those who are not skilled in this intelligence may need to adopt a different approach toward learning and improving their cultural intelligence.
According to Earley and Peterson, cultural intelligence is a significant improvement over existing approaches because it “provides an integrated approach to training dealing with knowledge and learning, motivation and behavior, and is built upon a unifying psychological model of cultural adaptation rather than the piecemeal and country-specific approach in training.”Earley & Peterson (2004), p. 101. David Thomas and Kerr InksonThomas & Inkson (2003). wrote that, compared to emotional and social intelligence, cultural intelligence theory includes the influence of cultural factors and their impact in intercultural interactions.
Emotional intelligence is one’s ability and capacity to identify, assess, and manage one’s emotions as well as others’ emotions. Although extremely important, emotional intelligence “presumes a degree of familiarity within a culture and context that may exist across many cultures for a given individual.”Earley & Peterson (2004), p. 105 Similarly, the social cues picked up and used by someone with high social intelligence—that is, the ability and capacity to sense one’s inner state, feelings, and thoughts in relation to one’s social environment, and react appropriately in this environment for social successGoleman (2006), pp. 83–84.—differs from culture to culture.
Earley and Peterson argue that adaptation is a requirement when one enters new cultural contexts, and cultural intelligence provides the theoretical background for understanding how one would need to adjust, adapt, or reinvent oneself based on the culture and the situation.Earley & Peterson (2004). Someone with high emotional and social intelligence is not guaranteed to be culturally intelligent, although having those skills can make it easier for them to learn about cultural intelligence. This is illustrated in the following case study.
Martha works as a program director for a large nonprofit that directs volunteer programs. Her co-workers describe her as, “personable, outgoing, empathic, and caring.” Whenever there is conflict or unsettled business, she is the “go to person” for helping her colleagues work out their issues. Her ability to be empathetic enables her to understand others’ thoughts and feelings as well as their intentions.
When Martha gets upset or frustrated, she “takes a pause” or will back away from the issue or person until she can get a hold of her emotions. If Martha is asked how she manages her emotions, she replies that meditation and exercise help her to regulate how she feels from moment to moment. She’s even led agency wide sessions on self-care and exercise.
Volunteers who work for Martha love that she cares about their needs. During workshops and events she introduces volunteers to one another, helping them to learn about and get to know each other. Martha is also very attuned to those around her by listening and observing, which makes her a great program director for volunteers.
Martha’s emotional and social intelligences are high, which makes it difficult for Lorraine, Martha’s direct supervisor, to understand why Martha has such challenges working with people of cultural groups different than her own. Martha, as her jovial self, is always kind and thoughtful, but sometimes she will say culturally inappropriate things, not aware that she’s said them.
One of the volunteers who is Southeast Asian has noted, “I like Martha but it seems like she just doesn’t understand me. Like the time I had to cancel my tutoring shift. No one was watching my sister’s baby so I had to watch her. I told Martha and she was real nice and understanding, but I feel that she didn’t really understand that I have an obligation to my family before this volunteer job. I had to explain to her that this is what it’s like in my culture, that family comes first. Then, she nodded and understood.”
In this case, although Martha is empathic, she does not understand that the volunteer has very specific cultural needs. Her empathy is not viewed as authentic because Martha does not understand, nor does she pick up on, the cultural cues, thus leading the volunteer to feel the way she feels. Empathy is a good foundation for intercultural relationships, but awareness of cultural nuances is critical for making the connection.
The following describes other ways in which scholars and practitioners believe cultural intelligence is different from other approaches:
• Cultural intelligence is a growing field that is continuously being researched and tested in many societies. A search on the Internet for the word “cultural intelligence” yields over 2.7 million hits. When searching for academic papers and scholarship, the word yields almost 1.5 million hits. Other intercultural approaches do not yield as much universal appeal as cultural intelligence.
• Cultural intelligence demands that leaders gather more than knowledge of cultural facts. It is awareness of how culture works, of the values and beliefs that ground a person’s thinking and motivation, and of exploring behavioral intelligence.
• Cultural intelligence emphasizes a circular path, not a linear one; this means that, over time, one will continue to learn and their cultural intelligence will expand. It is not a step-by-step process that culminates in an “ultimate outcome.” Rather, through cultural intelligence, one learns more about him- or herself and his or her ability to interact with different cultures. There is always room for improvement and development in cultural intelligence.
• Cultural intelligence does not speak to specific cultures. Cultural intelligence is a broad approach that looks at developing a set of skills, as well as awareness and knowledge, that help you to adapt and interact with multiple cultures. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/03%3A_Cultural_Intelligence_Defined/3.03%3A_What_Makes_Cultural_Intelligence_Unique.txt |
We have not even to risk the adventure alone…the labyrinth is thoroughly known. We have only to follow the thread of the hero path…and where we had thought to slay another, we shall slay ourselves. Where we had thought to travel outward, we will come to the center of our existence. And where we had thought to be alone, we will be with all the world.
Joseph Campbell, The Power of Myth
Labyrinths often serve as metaphors for personal journeys into the self and back into the world. In a labyrinth, there is one path to the center, and that same path leads you out. You make the choice to enter the path and start a journey. You make the choice to continue the journey or to end it by retracing your steps to the place you entered.
You can think about your journey into cultural intelligence as entering a labyrinth. It is not a maze; rather, it is journey that brings you to a deeper awareness of yourself and your place in the world. In a labyrinth, you find yourself walking around short curves, long curves, around edges of the circle, getting closer to the center. As you do so, you may feel a variety of emotions and thought: hesitation, confidence, motivation, ease, caution, or reflection. In the labyrinth, we become the observer of these thoughts and emotions. As Carlson noted, “We can simply step back and watch the show. It’s really just like watching a movie on the screen.”Carlson (2005), p. 50.
The labyrinth has long served as a metaphor of change and growth. Walking the labyrinth is a time of exploration and discovery. Careful listening and the willingness to take risks, and to challenge yourself, lead you to a transformation. This transformation encompasses a new, expansive vision of possibilities in your world. It serves as a container for your experiences in life: fun and play, disappointment and sadness, grief and loss, joy and prosperity, success and failure. When you look at the labyrinth as a metaphor for your cultural intelligence journey, you will see that your path is sometimes shared with others, and, at times, it is yours alone.
As Joseph Campbell noted, everyone goes through a psychological transformation that brings them to a more fulfilling life.Campbell (1988). Cultural intelligence is a process and a tool to help you evolve, to help you take the risks required when in unfamiliar cultural interactions. When applied, you will notice that you have gained a new consciousness of your place in the world.
3.05: Summary
• Cultural intelligence is the ability to adapt successfully to unfamiliar cultural settings.
• There are three elements to cultural intelligence: metacognition and cognition, motivation, and behavior.
• Cultural intelligence can be expressed as the ABCs of CI: acquire (knowledge), build (strategic thinking), contemplate (motivation), and do (behavior).
• Cultural intelligence is more comprehensive than emotional and social intelligences.
• People who have high emotional and social intelligences do not necessarily have high cultural intelligence.
• CI is more than knowledge-gathering; it does not speak to one specific culture.
• Your journey into cultural intelligence can be seen as entering a labyrinth. Labyrinths serve as metaphors for personal journeys that lead to transformation and change.
• Practicing and applying cultural intelligence principles enables you to learn more about yourself and your relationship to the world. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/03%3A_Cultural_Intelligence_Defined/3.04%3A_The_Labyrinth_of_Cultural_Intelligence.txt |
Cognition is generally thought of as your ability to process information. As related to culture, you can think about it as the complete knowledge and experience you have gained about cultural situations and your interactions within those situations. Additionally, how you have thought or processed this information is stored in your memory. Your ability to retrieve this stored information is defined as cognitive ability.
For example, I was conducting a workshop on cultural intelligence for educators, and one of the senior managers raised a question about proper etiquette in Southeast Asian cultures, particularly Lao and Hmong, that were present in her school district. She said, “I heard from one of my colleagues that it’s considered rude if you touched or patted a child’s head; that it’s sacred. I tell my staff never to do this. Am I telling them the right cultural information?”
I replied that, yes, in some Southeast Asian cultures, touching or patting someone on the head is considered rude. “But, you have to realize that cultural information may not be true for every Southeast Asian child or parent you meet. Your awareness of this fact and your experiences related to this fact is a good thing to recall, but what if your new situation doesn’t fit into your past experiences and what you know? What do you do?”
What I pointed out to her was that her awareness of this cultural fact was not enough. Earley and PetersonEarley & Peterson (2004), p. 104. stated that providing training in specific cognitive knowledge for multiple cultures is impractical. What is critical is equipping a manager with metacognitive skills so that, with time and experience, he or she can acquire new information concerning the cultural issues present in his or her team. With cultural intelligence, when the information you have does not fit a new situation, you have to be able to take in new information and reformulate it. Given this new information, you need to be flexible enough to reorganize how you think about the situation and the cultural fact(s) you have stored in your memory.
Throughout my educational and consulting sessions, I meet with people who are most concerned about “getting cultural facts and information correct.” By this I mean they are interested in “what they can and can’t do,” or “making sure they act within the boundaries of proper behaviors.” Some even want a “10 commandments of cultural etiquette.” As a result, most people end up with cultural facts and information that help them understand the culture, but not the ability to work with, and adapt to, the culture.
The reality is, when you are working on a multinational team or supervising and leading a multinational staff, you need to have a higher level of thinking (cognition). This is where cultural strategic thinking really matters and where metacognition becomes important.
4.02: What is Metacognition
Metacognition refers to “thinking about thinking” and was introduced as a concept in by John Flavell, who is typically seen as a founding scholar of the field. Flavell said that metacognition is the knowledge you have of your own cognitive processes (your thinking).Flavell (1979). It is your ability to control your thinking processes through various strategies, such as organizing, monitoring, and adapting. Additionally, it is your ability to reflect upon the tasks or processes you undertake and to select and utilize the appropriate strategies necessary in your intercultural interactions.
Metacognition is considered a critical component of successful learning. It involves self-regulation and self-reflection of strengths, weaknesses, and the types of strategies you create. It is a necessary foundation in culturally intelligent leadership because it underlines how you think through a problem or situation and the strategies you create to address the situation or problem.
Many people become accustomed to having trainers and consultants provide them with knowledge about cultures to the point where they are dependent on the coach, mentor, trainer, or consultant. However, they need to learn to be experts in cultural situations themselves through metacognitive strategies such as adapting, monitoring, self-regulation, and self-reflection. Culturally intelligent leaders can use metacognition to help themselves and to train themselves to think through their thinking.
Metacognition is broken down into three components: metacognitive knowledge, metacognitive experience, and metacognitive strategies. Each of these is discussed in the following sections.
Metacognitive Knowledge
Metacognitive knowledge involves (a) learning processes and your beliefs about how you learn and how you think others learn, (b) the task of learning and how you process information, and (c) the strategies you develop and when you will use them. Let us say you have to learn a new language in 6 months. Here is how you would think about it, using metacognitive knowledge:
• Learning Process: I am good at learning new languages and I think I can do this in the time period I have been given.
• Task of Learning: To complete this task, I will need to think about the following:
• How soon can I get information to start learning the language?
• How long will it take me to learn the language?
• What information is available to me to learn this new language?
• Is this language similar to a language I have learned before?
• Will I be able to learn the language in time?
• How hard will it be for me to learn this language?
• What do I need to do to learn the language?
• The Strategies: I think learning this new language is going to take me 12 months, but I only have 6 months to prepare. I better find other ways to me meet this goal. I think I will find out if there is an accelerated language class that I can take. Maybe I should consider hiring a private tutor, or maybe I will just focus on learning the basics of the language.
Metacognitive Experience
Arnold Bennett, a British writer, said that one cannot have knowledge without having emotions.Bennett (1933). In metacognition, there are feelings and emotions present that are related to the goals and tasks of learning. These components of metacognition speaks to metacognitive experience, which is your internal response to learning. Your feelings and emotions serve as a feedback system to help you understand your progress and expectations, and your comprehension and connection of new information to the old, among other things.
When you learn a new language, for example, you may recall memories, information, and earlier experiences in your life to help you solve the task of learning a new language. In doing this, your internal responses (metacognitive experience) could be frustration, disappointment, happiness, or satisfaction. Each of these internal responses can affect the task of learning a new language and determine your willingness to continue. Critical to metacognition is the ability to deliberately foster a positive attitude and positive feelings toward your learning.
Metacognitive Strategies
Metacognitive strategies are what you design to monitor your progress related to your learning and the tasks at hand. It is a mechanism for controlling your thinking activities and to ensure you are meeting your goals. Metacognitive strategies for learning a new language can include the following:
• monitoring whether you understand the language lessons;
• recognizing when you fail to comprehend information communicated to you in the new language;
• identifying strategies that help you to improve your comprehension;
• adjusting your pace for learning the information (for example, studying for 2 hours, rather than 1 hour, every day);
• maintaining the attitude necessary to ensure you complete the lessons in a timely manner;
• creating a check-in system at the end of each week to make certain you understand what you have learned.
As one business manager of a Fortune 300 company told me,
Understanding cultural strategic thinking is like this: When I work with people of different cultures, this is a framework and approach to help me understand how I think when I work with them. It helps me to recognize the cultural experiences I’ve had, and to identify preconceived notions I might have about their culture, whether it’s race/ethnicity, social culture, age group—you name it. Cultural strategic thinking forces me to create experiences and new learning that helps me to accomplish my objectives as a global manager.G. Menefee (personal communication, May 12, 2010).
Individuals like this leader are good at applying strategies that focus their attention on the goal at hand. They search for, and derive meaning from, cultural interactions and situations, and they adapt themselves to the situation when things do not pan out as they expected. Culturally intelligent leaders also monitor and direct their own learning processes. They have established a high motivation for learning the metacognitive process, either because they know it is a benefit or because others tell them it is beneficial to them.
Knowledge of factual information and basic skills provides a foundation for developing metacognition. Metacognition enables leaders to master information and solve problems more easily. When a leader has mastered the basic skills needed for intercultural interactions, they can actively engage in the interaction because they do not have to pay attention to the other dynamics and demands of the situation. Culturally intelligent leaders are able to practice metacognition, and they are not afraid to use it in their everyday life.
For those who lack basic intercultural skills, it is more difficult for them to engage in the interaction. They are more occupied with finding the “right information,” the “right skills,” and the “right facts” needed to solve the problem. In such situations, these types of leaders spend little time developing their metacognitive skills, and the result is likely an inefficient solution to a problem. Developing a laundry list or checklist of do’s and don’ts will not assist leaders in improving their cultural intelligence. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/04%3A_Thinking_About_Thinking/4.01%3A_What_is_Cognition.txt |
How can you improve your strategic thinking? Basic strategies for improving thinking include (a) connecting new information with what you already know, (b) selecting your thinking strategies carefully and intentionally, and (c) planning, monitoring, and evaluating your thinking strategies and processes.
Connecting New Information
Strategic thinking is “thinking about thinking.” It is being conscious of your thinking processes, such as how you have gathered and organized the information and experience in your memory (old information), and then how you reorganize it (new information) to fit a new situation. You have to connect the new information to what you already know in order to help make sense of what actions to take. You can do this by identifying what you know and what you do not know about a cultural situation. Here is an exercise to help you identify old and new information. Take a sheet a paper and draw a line down the middle of the sheet to create two columns. At the top of the left column, write, “What I know,” and at the top of the right column, write, “What I want to learn.” As you research, explore, and interact with a cultural situation, people, or information, you will learn to clarify, revise, verify, or expand your understanding of the situation.
Let us look at the example of Betsy, who is a product manager for a local distributor of processed foods and snacks. With a growing Hispanic population that has an increasingly large purchasing power in the United States, her company wants to expand into the market and seize on this opportunity and potential for growth. This is not a new market for the business, but it requires that her team think strategically about what they know and do not know about this consumer base.
Table 4.1 Identification of Knowledge Gaps
What I Know What I Want to Learn
Between the years 1991–2013, the projected growth of Hispanic purchasing power is 560%. Differences in lifestyles among Hispanic groups.
Hispanics are the largest minority group in the United States. Reasons for immigration or coming to the United States.
By 2020, the U.S. Hispanic population will triple. Cultural etiquette in doing business with Hispanics.
Family is central to Hispanic communities. History of Hispanic culture in the United States.
A large percentage of Hispanic families are from low-income families.
Next, Betty and her team will need identify the strategies that will help them to be more intentional with their work.
Selecting Intentional Thinking Strategies
Based on this exercise, Betty has identified strategies that will connect new information to the old in the following ways:
Figure 4.1 Creating Intentional Strategies
By connecting old information with the new, Betty is making conscious choices and decisions about what she knows and what she does not know. This sets her up with strategies that are most appropriate for her. Strategic thinking is most useful when you find strategies that work appropriately for your level of knowledge, building upon what you know. As indicated earlier in the chapter, if this new knowledge is basic information and Betty does not have this, she can be easily distracted, which may create interruptions in her learning and practice of strategic thinking.
Planning, Monitoring, and Evaluating
As Betty collects information related to her actions, she will add or revise her strategies, as needed, because her knowledge base has grown and what was “new information” at one time is now old information. Betty will put in place strategies that help her to monitor her progress toward her goal as well as to evaluate how she thinks about each strategy. Because the information is new to her, and if the information is basic knowledge that she needs, she will need to pay attention to her mind’s ability to be easily distracted. When she is aware of this, she can retrain her brain to identify the distraction and then refocus on her goals. There are a variety of strategies she can use to plan, monitor, and evaluate her progress.
One strategy Betty has employed is to create the time and space with her team to discuss her cultural experiences. This allows her to process, out loud, the knowledge she has obtained and forces her to think about her thinking, that is, her metacognition. Because she puts this strategy in place, she can understand what her mind is processing during her learning, and she is then able to identify and focus on her strengths and improve upon her weaknesses. When she does this with a group, her peers help her to learn about her thinking while she helps them to learn about their learning processes. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/04%3A_Thinking_About_Thinking/4.03%3A_Techniques_for_Developing_Strategic_Thinking.txt |
The basics of developing and practicing cultural strategic thinking are to (a) connect new information to the old, (b) select the appropriate strategies, and then (c) plan, monitor, and evaluate the strategies you have put in place. This section of the chapter provides ideas that will help you to increase your cultural strategic thinking.
Peer Learning
A strategy that is often employed in the practice of cultural strategic thinking is to create peer-learning opportunities to explore cultural interactions and resolve cultural problems. Doing this provides you with a language for how you process cultural interactions and problems, and your peers can help you to create that language and help solve the problems. As a leader, this is a great way of providing a model for those who have difficulty with cultural strategic thinking. It does so by sharing with them a language and a process, and by helping to point out the cultural strategic thinking pieces of the process, which can be done by asking and clarifying the situation for them. Think about it as playing cultural detective: You ask your peers questions, and they clarify the information for you, and when they ask you questions, you clarify your thinking process for them.
Writing Your Experiences
A useful tool I have used in my workshops and classes is writing down experiences and thoughts related to a cultural situation. I encourage you to write down your emotions and feelings, the ambiguities and inconsistencies, and the challenges and successes of working interculturally. Your writing serves as a reflection of your thinking processes and how you have dealt with, or how you could not deal with, the process. It also serves as a memory of your experiences, which you can later refer back to and learn from.
Gaining Cultural Knowledge
In gaining cultural knowledge, it is very helpful to get into the habit of checking your facts and knowledge about a culture. You can do this by using multiple sources and venues. If you come across a situation in which a cultural fact seems to contradict what you know, take the time to learn about the difference and the nuances related to that cultural fact. Using that cultural situation as a “Kodak moment,” take the opportunity to reread the picture to see if you really understood how that cultural fact was used. In your review of the situation, you may need to research unfamiliar terms or gestures used, or you may need to break down the picture and rebuild it, step by step, to understand if you really understood the whole picture.
Thinking, Being, and Staying Positive
Essential in cultural strategic thinking is your ability to conjure and be positive about your learning experiences. Someone who holds a negative perspective about, or who had a negative experience, working with different cultural groups will continue to have difficulty working with the groups. Negative attitudes and impressions will hinder your work. You have to think positively about a situation, and you need to be and stay positive, maintaining a positive energy and attitude throughout. I have certainly come across leaders who have attended my sessions because “leadership told them they had to,” and it affects their learning environment in a negative way and often interrupts the learning of their peers. Your ability to be a culturally intelligent leader depends on your willingness to maintain a positive attitude.
Finding a Coach or Mentor
Along the lines of processing your cultural situations out loud, it would be helpful to find a coach or mentor that can help you analyze your thinking. In cultural strategic thinking, it is important to talk about what you will do or what you have to do. Some people will talk to themselves; others find it helpful to have someone to talk to. As in peer learning, talking to someone else gives you the opportunity to break down your thinking processes.
Being an Observer
One of the best things to do in developing cultural strategic thinking is to learn to be an observer. Through observation and active listening, you pick up what you normally do not see. Observation is acquired through day-to-day activities in your life by making a conscious decision to be open and alert. Pay attention to the verbal and nonverbal cues of various situations; look around your environment and note the various symbols and artifacts. Culturally intelligent leaders must have excellent observation skills, never failing to hear and see the tangible and intangible. You can do this by reminding yourself or by setting goals centered around the following actions:
• Listen with an open mind
• Be open to new ideas
• Suspend judgments of people and their beliefs
• Ask people questions
• Silently ask yourself questions
• Be open to experiences that are unfamiliar
Active Listening
Active listening is your ability to understand, interpret, reflect, and respond to what you have heard. It is a critical skill in cultural intelligence because the behavior acknowledges that you have really heard what another person has said. Active listening focuses your mind on the speaker, and, if done repeatedly and successfully, you are able to build trust and a relationship with others. It can facilitate an effective cultural interaction with less conflict, confusion, and frustration. Practicing to be an active listener is making a conscious choice about your responses to others. Because cultural intelligence is intentional, you are also better able to regulate your emotions and feelings.
Changing Your Questions
Marilee AdamsAdams (2004). proposes that when you change your questions in any given situation, this allows you to change your thinking. There are two types of questions: questions that involve judgments and questions that involve learning. We ask both types of questions, and we choose which ones to ask in any given situation. Asking questions in a different way provides us with another perspective.
Table 4.2 Judger vs. Learner Questions
Judger Learner
What’s wrong? What works?
Who’s to blame? What am I responsible for?
How can I prove I’m right? What are the facts?
How can I protect my turf? What’s the big picture?
How can I be in control? What are my choices?
How could I lose? What’s useful about this?
How could I get hurt? What can I learn?
Why is that person so clueless and frustrating? What is the other person feeling, needing, and wanting?
Why bother? What’s possible?
Note. Adapted from Marilee G. Adams, 2004, Change your questions, change your life: 7 powerful tools for life and work, San Francisco, CA: Berrett-Koehler, p. 49.
Cultural strategic thinking may seem overwhelming at first, but as with any new learning, you need to break your plan into smaller steps that will help you to accomplish your goals. When you get into the habit of cultural strategic thinking, you will begin thinking on an unconscious level and not even recognize that you are using strategic thinking. You will notice it when others marvel or comment at your ability to effectively manage cultural interactions.
Earley and PetersonEarley & Peterson (2004). wrote that learning about a new culture requires putting all the pieces of a pattern together when you do not know the totality of what that whole picture should look like. Cultural strategic thinking is essential because it is this higher strategic thinking that enables you to process the new information and reinterpret it in a new situation. Cultural strategic thinking helps you to discard what you think you know and to apply new information concerning what the situation could be. By training your mind to think at a higher level, you create new maps of cultural situations, which help you to function more effectively.
4.05: Summary
• Leaders must be aware of how they process information related to culture and their ability to think about this thinking, which is called metacognition.
• Metacognition is an essential core of successful learning, and leaders who lack the basic knowledge about working with cultures will have more challenges in their ability to be culturally intelligent.
• Culturally intelligent leaders create strategies that help them focus on the goal of their cultural interactions. They use feedback from the situation and adapt it to create a new picture, while creating new learning patterns for themselves.
• Strategies that can help leaders build their strategic thinking include peer learning, coaching and mentoring, reflecting on their thinking processes in a journal or book, and being an observer and active listener.
• Strategic thinking techniques address the basic development skills necessary in metacognition: connection of new information to old, intentionally selecting the appropriate strategies necessary for that situation, and planning, monitoring, and evaluating the strategies and one’s progress. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/04%3A_Thinking_About_Thinking/4.04%3A_Cultural_Strategic_Thinking_Techniques.txt |
Self-efficacy, as defined by Albert Bandura, represents your perception of your abilities to meet a goal you have set for yourself. It is similar to self-confidence. Self-efficacy is a foundational component in cultural intelligence. For the past 25 years, scholars have researched this topic and the strategies that leaders can use to encourage higher levels of efficacy in their employees.
People with lower self-efficacy will have challenges throughout intercultural processes because they do not believe that they will be able to solve the problem. They do not feel they have the skills needed to work through the issues. Conversely, leaders who have higher levels of self-efficacy believe they can overcome obstacles, whether difficult or not. They have an easier time engaging in problem solving and finding strategic approaches for solving the issues before them.
Table 5.1 Self-efficacy Perspectives About Unfamiliar Cultural Settings
High Self-Efficacy Perspective About Unfamiliar Cultural Settings Low Self-Efficacy Perspective About Unfamiliar Cultural Settings
The task is to master unfamiliar settings The task is “too big for me” to handle
Sets higher commitment to goals and process No commitment to goals and process
Internal motivation to work diligently Motivation is decreased; little to no effort
“If I fail, I’ll try again” “It’s too stressful, complicated, and frustrating.”
Focus on success and removing obstacles Focus on obstacles and challenges
Visualize positive experiences and outcomes Visualize negative experiences and outcomes
5.02: The Role of Self-Efficacy in Cultural Intelligence
As a leader working with different and unfamiliar cultures, your self-efficacy determines how you think, feel, and behave in cultural situations. It is your beliefs about what you can and cannot do. It is your confidence level in intercultural situations and the results that it has on your ability to adapt to another culture. It is your belief that you have the ability to work through cultural issues that can contribute to your perseverance in daunting, challenging situations.
If you have a high level of self-efficacy, you are not afraid to take on cultural challenges. Instead, you perceive the tasks involved as if they are something to be mastered. Your belief stirs up an internal motivation for you to be successful and to fully engage in the problem. You are more likely to set challenging goals and diligently work through activities. You are also more apt to maintain a commitment to the process and the goals. When the going gets tough, you keep on going because of your perseverance and resiliency. Take, for example, the case of Jerry and Mingxia:
Jerry works in a large university and has managed the day-to-day operations of the study abroad center for three years. Because of the focus on studying abroad, many of the students who work in the center are from outside the United States. Most recently, Jerry hired a student from China for a work study position coordinating front desk activities. Jerry has enjoyed working with Mingxia thus far, but he has noticed that when he needs tasks to be accomplished, she doesn’t give him a definite “yes” or “no” and sometimes provides an ambiguous response to his questions. He’s quickly realizing that when she says “yes,” it means she understood him but it doesn’t mean she agrees. At first he is frustrated, but that frustration gives way to interest and fascination about cultural differences. He’s had to sit down with her several times to discuss the tasks, but he approaches the conversation as a learning opportunity for him and her. He realizes that managing this cultural interaction is necessary for the work of the department. He has found that even though it takes more effort to build cultural understanding, he has seen it pay off. The other day, Mingxia brought in her friends who were interested in working with the center because they heard it was a great working environment and that he was a great boss.
Jerry’s perception of cultural challenges was to change them into opportunities; he adapted to the situation at hand. This is a vastly different response than what would be observed in a person with a lower self-efficacy. These individuals tend to doubt their abilities in unfamiliar cultural settings. They tend to avoid challenging situations and often visualize potential failures and setbacks. Individuals with low self-efficacy attribute their failures to not having the right competencies or information for the situation, whereas those who have high self-efficacy attribute failures to not putting in the right amount of efforts required.
Using the CI model in Figure 3.1 "Cultural Intelligence Model", Jerry can think about this situation in this way:
Acquire: Jerry needs to acquire cultural knowledge to help him understand the situation better. He already knows from his interactions with Mingxia that language, particularly responding with “yes” and “no,” may not be productive in this case. He also knows that Mingxia is from China and has connected his department with future employees. Jerry also could learn more about students from China and in particular, how they like to work with someone who is older than them.
Build: In this situation, Jerry can use what he knows and what he would like know to create new ways to interact with Mingxia. He may have to try the strategies and test them out. A culturally intelligent leader would think about how he could plan, monitor, and evaluate his strategies. During the process, he learns what works for Mingxia and what does not. For example, Jerry may want to try asking Mingxia questions that are not closed ended or require “yes/no” responses.
Contemplate: Along with his strategies, he may remind himself to pay attention to Mingxia’s verbal and non-verbal cues. He could try either or both of these strategies, paying attention to his surroundings–both the visible and invisible pieces of culture; as he receives a response, he will adapt as needed. During the contemplation stage, Jerry can choose to suspend his judgments. When he notices he has judgments or a negative emotion is present, he can take a step back to listen and recognize what cultural scripts are occurring.
Do: As he interacts with Mingxia on a daily basis, he can learn to apply the fourth principle of CI. He can do this by asking himself how he might appear to Mingxia. Is he too authoritative? Too accommodating? Did he use words that were unclear? Was he too direct? These questions can help Jerry to use CI principles on a daily basis, and as a result, he learns more about himself and builds his self-efficacy.
Jerry’s self-efficacy helps him to be a better culturally intelligent leader. When doubt is present in individuals it detracts from one’s efforts. People with lower self-efficacy give up more easily and lower their expectations and goals. They see situations as not only uncomfortable but also, in some cases, threatening. Avoiding uncomfortable and threatening situations is a top priority for these individuals because it produces more anxiety, stress, disorientation, and frustration. Unfamiliar cultural situations become stressful and can be depressing. The following is an example of an American educator assigned to work with an Iraqi family:
Melissa is meeting Ashraf’s parents to discuss his progress in class. This is the first time she is meeting his parents who have emigrated from the Middle East recently. When they arrive late to the meeting, she greets the father by offering to shake his hand, as common in American society. He looks puzzled and shakes her hand. Then, Melissa turns to the mother and proceeds to shake her hand. Ashraf’s mother looks at Melissa, very confused, and then looks at her husband. A few seconds pass, but eventually she reaches out to shake Melissa’s hand.
During the conversation with Ashraf’s parents, Melissa asks both parents questions about Ashraf’s home life. She wants to get a sense of how Ashraf is using the information he has learned in class in his home environment. Throughout the meeting, Melissa senses that the father is becoming more impatient and suspicious, and she is uncertain as to why. She notices that the father dominates the conversation and responds to the questions she poses to the mother. He also seems evasive when responding to her.
Melissa is beginning to feel very frustrated with the father. She finds herself repeating a lot of what she’s said and explaining to the parents the reason for the meeting. Halfway through the meeting she knows she isn’t going to accomplish what she initially set out to do. She’s dreading a second meeting with the family, and she’s becoming more and more impatient with the father. Why would he treat his wife like that? Doesn’t he realize that she can answer for herself? For the rest of the meeting, Melissa loses her focus and finds herself thinking about other things. The meeting ends earlier than scheduled, but she’s more than happy that the meeting is over.
After the meeting, Melissa shares the experience with her colleagues. She says, “The dad was always interrupting and the mom was really quiet. I’m pretty sure she’s scared to disagree with him. Now, I have to meet them again because I didn’t even get what I needed from them. This second meeting better not be a waste of my time. It’s not like we have the luxury in this job to meet parents whenever they want.”
Melissa’s thoughts and actions revealed her stress and her level of discomfort with the situation. Because this is the first time Melissa has met with a Middle Eastern family, she does not know the proper cultural etiquette. She may not be aware of the cultural information she needs ahead of time to work with the family, which may explain why she does not pick up on the mother’s hesitation when shaking hands. Additionally, Melissa uses judgments based on her cultural values system to explain the uncertainty she feels. For example, she finds the father to be suspicious and evasive. How does she know that what she sees is a representation of suspicious and evasive behavior? She only knows what she sees based on her cultural experiences—her cultural lens.
Notice that in the latter half of the meeting, Melissa lowers her expectations and focuses her attention elsewhere. This is evident of her thinking, which implies that her cultural experiences are the only ways to interpret the world. Rather than taking responsibility for how the meeting was run, she puts the blame and responsibility on the family. To her, the father’s constant interruptions and the mother’s silence represented disregard for her objectives; thus, her comment, “It’s not like we have a luxury in this job to meet parents whenever they want.”
What can be done to help Melissa improve her self-efficacy? Using the principles of CI, Melissa can think about future cultural interactions in this way:
Acquire: Melissa can identify what she knows and does not know about Middle Eastern culture and in particular, Iraqi culture and customs. By identifying these areas, she creates a chart of her knowledge. Culturally intelligent leaders need to know what gaps exist for them when they interact with different cultures. In this case, Melissa will need to start at the basics, not just learning about Iraqi culture; she needs to learn about her own culture in order to understand how Iraqi families may be different from her own.
Build: Melissa can build her knowledge of the culture by gathering information from different sources such as books, documentaries, attending local events, or speaking with someone who knows about the culture. These are strategies she builds for herself to understand more about Iraqi culture. Some of these may be challenging to her because she may have never tried the strategies or activities before. But, as she conducts the activities, she can pay attention to how she feels and what she is thinking. By doing this, she will understand where her level of comfort is and where she needs to be challenged.
Contemplate: When applying this component of CI, Melissa may create a goal for herself to listen more to families’ nonverbal cues. Paying attention to this enables her to suspend her assumptions. She may even reflect on what assumptions come up for her before, during, and after meeting with families. In contemplation, Melissa may reflect on her own motivation to helping families. How committed is she to helping all families, no matter their ethnic background? How motivated is she to keep trying even when she feels uncomfortable? These are some questions that she can ask herself and then find solutions to, moving her forward in a positive manner.
Do: Melissa’s work in this particular CI element is to observe her own behaviors with families from different cultural backgrounds. As she practices her strategies, she can monitor and evaluate whether the behavior was appropriate or not by observing the responses from others. By checking her level of adaptability in the meetings, she will learn to mimic and mirror the appropriate cultural gestures and cues. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/05%3A_I_Think_I_Can_and_I_Will/5.01%3A_What_is_Self-Efficacy.txt |
Have you ever been to a busy mall, event, or festival, or shopping during the busiest time of the season, and you could not find a parking spot? Driving all around, let us say that you finally located a spot, only to find that you cannot park there because there is a car that double-parked in that space. What is your reaction? What if this situation consistently happens to you and the parking lot is in a different city or state, a different region of the country, or another country all together? What is your reaction then? What assumptions would you make about the people who drive the car? What assumptions might you have about the people who live in that city, state, region, or country?
In cultural intelligence, a development of high self-efficacy is necessary in unfamiliar cultural environments. You do not have a choice but to develop a higher self-efficacy. This area of the human potential is spoken about in the study of emotional intelligence. Daniel GolemanGoleman (1995). was the first to popularize the concept of emotional intelligence (EI). Building on the work of John Mayer and Peter Salovey, Goleman distilled EI into a relatively concise set of five skills, addressed the following questions:
• How well do you know your emotions?
• How well do you manage your emotions?
• How do you adapt or change based on your emotions?
• How well do you recognize the emotions in others?
• How well do you handle relationships?
Self-management of emotions plays a critical role in leadership. As Goleman notes, managing emotions is a full-time jobGoleman (1995).. For leaders, self-management encompasses a multitude of competencies that include emotional self-control, that is, the ability to stay calm and clear-headed during periods of high stress or during a crisis. It is important for leaders to develop ways of dealing with their disruptive impulses and emotions, especially in intercultural situations.
Self-efficacy requires adaptability and initiative. Adaptability is your ability to juggle multiple demands, adapt to new challenges, and adjust to new changes. Adaptability allows you to effectively deal with the ambiguities of cultures. Your initiative is your competency to seize the challenges and turn them into opportunities. You create and act rather than wait.
Learning to develop an optimistic perspective will help you to improve your self-efficacy, thus improving your ability to be resilient to challenges. You begin to see the best in people and expect that changes will be positive. For example, Viktor Frankl, a man who survived the horrific experiences of the concentration camps in Nazi Germany, noted that even though he had suffered, he chose to see his experiences in the camps as one that held meaning for him. He said that choosing your own attitude in any situation is one of the most powerful freedoms provided to mankind.Frankl (1984).
Frankl shows that choosing one’s attitude can shift one’s perspective, thus creating new possibilities. His thinking on this subject matter has been instrumental in opening up new possibilities of thinking about the capacity of human beings to survive and find meaning in life. His book Man’s Search for Meaning provides a platform for existential therapy and logotherapy. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/05%3A_I_Think_I_Can_and_I_Will/5.03%3A_Emotional_Intelligence_and_Self-Efficacy.txt |
What is mindfulness? According to Boyatzis and McKee, mindfulness “is the capacity to be fully aware of all that one experiences inside the self—body, mind, heart, spirit—and to pay full attention to what is happening around us—people, the natural world, our surroundings, and events.”Boyatzis & McKee (2005), p. 112. Ajahn Sumedho,Sumedho (2001). in Teachings of a Buddhist Monk, wrote that mindfulness is about a full awareness of what is going on inside; it not necessarily about concentrating on a particular object or thing, because our concentration does not last long. Rather, being mindful means allowing for the experience of the moment to arise, whether that experience is confusion, hurt, laughter, or excitement.
Many people equate the concept of mindfulness to Eastern philosophers who look at mindfulness as a process of self-awareness that directs the self to take part in being in the “present moment.” This reflective process is nonjudgmental, meaning that mindfulness is accepting whatever is happening. Mindfulness is not thinking in terms of categorizing experiences or labeling them; rather, it allows the experiences to just be. It does not associate with the ego—“I,” “me,” and “mine.” Instead, it looks at only the experience(s) in the present moment from an objective stance or that of an observer. In this way, mindfulness provides experiences so profound that it can, and has, changed perspectives and relationships.
Mindfulness has been shown to be effective in innovation and creativity. The phrase “think outside of the box” eludes to mindfulness. To “think outside of the box” means that you cannot categorize, label, or see the issue or object in the same perspective as you did before. You must choose a different way to look at what is in front of you. This would mean that you need to challenge yourself to do things outside of your comfort zone, and, oftentimes, you are doing something you would not even think about doing. In this way, mindfulness is a process, not an outcome.
Culturally intelligent leaders who use mindfulness are generally more open to possibilities and different perspectives. They allow themselves to receive new information even if they believe that what is in front of them is indeed fact or true to them. A state of mindfulness helps to create possibilities and different avenues for growth. Take, for example, the following situation:
Two politicians from opposing parties are in disagreement about actions to take regarding a potential new immigration policy. Both politicians recognize that there is an immigration issue in the country and that it has a significant impact on the economy. Both believe that controlling immigration into the country is the key to maintaining national security and ensures the health and well-being of the country’s citizens. One of the politicians believes that a way to control immigration is to round up all illegal immigrants and deport them. The other politician believes that only specific illegal immigrants should return to their country. Enter a third politician who has been listening to the argument. This politician sees both sides of the arguments and recognizes the truth in each statement. As a result of mindful listening, receiving, and reflection, this politician offers a third alternative that may contain components of the two opposing arguments or it could be a completely different way of thinking about immigration.
Mindfulness techniques help you to come to an awareness of your self-efficacy. Through mindfulness, you learn to see your perspective of a situation, whether objects, people, places, or ideas are involved. The connection between mindfulness and self-efficacy is such that when you use mindfulness, it helps you to focus on your performance and goals.
This next exercise is to help you use mindfulness to accomplish a goal. On a piece of paper, write down one goal you have (i.e., “My goal is to…”). This may be related to work, your family, your finances, starting a new business, purchasing a new car—anything you would like to obtain. Below your stated goal, write down five things you plan on doing to achieve this goal. Next, have two people (e.g., friends, neighbors, strangers) each write down five things you can do to achieve this goal. Then, review what you have written down to achieve your goal as well as what others have said for you to do to reach your goal. Now, respond to the following questions:
• How would you react if none of the plans you made turned out the way they were supposed to?
• What if, in the middle of working toward your goal, the goal changed?
• If you reached your goal exactly as you planned it, what would you have learned about yourself?
• What type of life do you think you would lead if everything went according to your plans?
Asking these questions not only helps you to be more mindful, it helps you to be more focused on your goals. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/05%3A_I_Think_I_Can_and_I_Will/5.04%3A_Mindfulness_and_Self-Efficacy.txt |
We make every effort to keep things as they are, because human beings, alone, lament transience. Yet no matter how we grieve or protest, there is no way to impede the flow of anything. If we but see things as they are and flow with them, we may find enjoyment in transience. Because human life is transient, all manner of figures are woven into its fabric.
Shundo Aoyama, Zen Seeds
Ellen LangerLanger (1989). wrote that we are all capable of mindfulness, as well as its counterpart, mindlessness. We subconsciously take part in mindlessness, out of habit or repetition, or out of our own self-placed limitations; however, if we focused on mindfulness, we would, in fact, be able to change our perspective of ourselves, our situations, our environment, or our world. Mindlessness can lock us into a specific way of being, thinking, and acting. We are not even aware that we are mindless unless we are in a situation where our mindlessness is challenged or we are conscious of being mindful.
Similar to this concept is the famous analogy of the cave by the Greek philosopher Plato. The analogy describes prisoners chained up in a cave, facing its wall; they have been there all their lives. They can only see shadows of animals, people, or other objects that pass by the entrance of the cave. Because they have never seen the outside of the cave, they do not know what is real except what they see in front of them. In other words, they accept the shadows as reality. However, one person breaks free from the chains and is able to see that the realities of the shadows—the objects, people, or animals behind the shadows—are real. He returns to tell the others about this new reality but is scorned and ridiculed. No one believes that there is another reality besides what they see in front of them.
Mindlessness occurs because we are accustomed to categorizing things in a way that does not allow for alternative possibilities. We automatically think in terms of limitations; therefore, we limit ourselves in our thinking and behavior. For example, a short person who, for all of his life, feels that his height limits and hinders him can never escape the category he has created for himself—that is that he is short. Even if others do not see the same reality as he does, his own reality is so strong that it affects his behavior and, ultimately, his sense of self-worth. It is the same with a woman who has been repeatedly told that she is stupid and worthless. She begins to see that this is the only way to live and starts to act out behaviors that mirror what she has been told.
Mindlessness can then lead to learned helplessness, a term that describes a state of futility after having experienced multiple failures. For example, if a mother constantly makes her daughter’s bed in the morning, and the mother tells her daughter that the only person who can make the bed the correct way is a mother figure, then the daughter will learn that she cannot make her own bed or even that she is incapable of making a bed. What if the mother decides that she no longer wants to make her daughter’s bed? The daughter could make her own bed, but she may also reveal that she does not know how to make a bed and that the only person who could make a bed is a mother figure.
Learned helplessness can also appear in cultural interactions. A number of times, I have met people who believe that “working with other cultures is too difficult,” and, as a result, their behaviors, their words, and their attitudes speak to this. This mentality perpetuates their behaviors and their inability to escape this learned helplessness. They give up quickly, they make excuses, or they justify their beliefs. By repeating movements, actions, behaviors, words, or thoughts, we enter a state of mindlessness. The tasks we have repeated become an unconscious part of us like driving, brushing our teeth, or eating.
The following exercises will assist you in thinking about how repetitive exercises can contribute to mindlessness and what the consequences of repetitive actions are:
• Recite the alphabet; then, recite the alphabet backwards.
• Sing the words to Twinkle, Twinkle, Little Star. Next, sing every other word to the song.
• On a piece of paper, write down what you noticed when you recited the alphabet backwards and when you skipped every other word of Twinkle, Twinkle, Little Star.
• Write a short note to a friend using your dominant hand. Now, using the nondominant hand, write the same short note to a friend. Write down what you noticed when you switched to your nondominant hand. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/05%3A_I_Think_I_Can_and_I_Will/5.05%3A_Mindlessness_and_Self-Efficacy.txt |
This section outlines practical approaches you can use in your daily life to help increase your self-efficacy, your emotional intelligence, and your capacity to be mindful.
Identify Moments of Success
You should identify experiences when you have successfully worked with cultures other than your own. You can also cultivate environments where you can be successful. Creating environments to practice and learn from your mistakes is essential for culturally intelligent leaders. When you build a space for others to learn, you encourage their sense of self-efficacy. You help to minimize their doubts about working with others, thus reducing their stress. However, focusing on creating easy successes can foster an environment where the individual comes to expect easy results. Find opportunities that both challenge and create success.
Teach and Promote Resilience
You can create a strong sense of efficacy by purposefully teaching resiliency. As a leader, it is about teaching others how they can bounce back from failures. Everyone needs to learn that they have what it takes to be successful in making it through difficulties. You can teach resiliency by promoting and pointing out positive behaviors and attitudes. It is also about helping those you lead to identify when they are using negative self-talk. The following case illustrates a leader teaching and promoting resilience with her employee.
Theresa, a senior sales manager, knows that a new hire, Jane, is new to working with a Hispanic population. What Jane knows about the population is based on media sources, research and papers she’s read, and what she’s picked up over time from her social network. Jane has a lot of work ahead of her if she wants to understand and work well with this consumer base.
Theresa provides constructive feedback to Jane in a variety of ways that encourages her to keep her motivation and interest high. She compliments Jane on things she does well and often says, “You’re making great progress.” Although there are times when Jane just doesn’t seem to “get it” as fast as she should, Theresa believes that eventually with training and the proper resources, Jane will succeed. Recently, Jane came back to the office with a big smile on her face. She was able to negotiate and secure a contract with a business in the Hispanic community. Theresa immediately congratulates her. “That’s fantastic. Way to go! Tell me all about it.”
As Jane recalls the experience, Theresa follows up with questions and prompts to convey her support and enthusiasm. When Jane recalls a minor setback in her conversation with the business, Theresa says, “Wait now. Don’t underestimate what you were able to do. That’s a minor issue and I know that if you secured the contract you must have adequately addressed that with the client.”
Jane hesitates, and then nods her head. “You’re right. I did. He seemed real relaxed after I explained it to him.”
Theresa notices the hesitation. To ensure that Jane realizes her good effort paid off, Theresa says, “Good work! Now that you’ve had this experience, what lessons learned can you take to your next sales opportunity?”
Theresa provides teaching moments of resiliency to Jane. As a culturally intelligent leader should, she is helping Jane learn the value of not giving up in the face of difficulty. She also points out the negative self-talk (verbal and nonverbal) that Jane slips into the conversation. Theresa ends the conversation on a positive note, continuing to show interest and support of Jane’s progress.
As Theresa is teaching Jane, she also learns about her own resiliency. Working with Jane is a new cultural experience for her: She is working with someone who is unfamiliar with certain aspects of her job and the consumers. As a person with many responsibilities, and one holding a position of leadership and authority in the organization, Theresa does not have a lot of time to manage Jane. Yet Theresa makes it a goal of hers to encourage and mentor Jane through the initial growing phase. Theresa’s resilience, her perseverance, and her perception of her own abilities in relation to the situation help her keep her motivation and interest high.
Provide Social Role Models
When you see someone who is successful and has accomplished the same goal as you, even in the face of resistance, you are more apt to believe that you, too, can accomplish those same goals. You believe that you have the abilities to master the tasks required to reach your goals. This is why finding a role model or mentor who is similar to you can help build your self-efficacy. If you are leading a team or department, you can find social role models to encourage your employees to build their self-esteem.
Self-efficacy increases when you are able to relate to your role model or mentor.Bandura (1994). If you surround yourself in cultural interactions with people who are not successful, even if you try very hard to be motivated in these challenges, this will undermine your efforts. Finding someone who has overcome cultural challenges will greatly benefit you. For example, read the following story about Tom, David, and Raj:
Tom and David both lead sales departments for separate divisions of their manufacturing company. In the past two months, both have traveled frequently and separately to India to work with a new division of customer service representatives who work with their respective departments. Ever since their boss informed them of this new venture, Tom and David have had separate emotions and experiences related to the new business situation.
Tom’s been less enthusiastic and interested in the project. Having never been out of the country and working only nationally, he’s hesitant and less thrilled than David about the new division and what it would entail. Similarly, David’s never been out of the country, but he has, over time, cultivated interest in cultural experiences different from his own. He has intentionally taken part in different intercultural events at local and national levels. He can’t wait to get started on the project.
Raj, their division supervisor, knows the abilities of each member of her staff. She requires them to purchase books and resources to help them learn about the local Indian culture. She’s even enrolled them in a language and culture class. She knows that Tom has been more reluctant to try new things. David seems to be gaining momentum and retaining more information that he’s learned compared to Tom. She notices the difference and thinks that Tom could learn from David.
Both have worked together closely in the past and share similar career and personal goals. Raj capitalizes on the relationship by building in a mentor-mentee component. She speaks to both of them about this new piece to their working relationship and receives an agreement and support from both. She also manages the relationship closely, ensuring that during this time Tom gets what he needs to be a culturally intelligent leader and that David receives mentorship and guidance from her. In this way, they’re working as partners, each serving as role models and mentors to another person.
As a leader, Raj is able to identify intercultural competency areas where Tom and David can both benefit. Raj knows that Tom needs support to boost his confidence level when working across cultures. She also knows that David has the self-confidence but needs assistance in understanding cultural facts. By building strategies that are appropriate for each person, she builds her team’s cultural intelligence. In the end, she learns about her own ability to work with two managers who have different individual cultural experiences.
Lead by Example
If you are able to manage and interact with different cultures more easily than your staff or employees are, model the way for them to understand how they could improve their own self-efficacies. Through your behaviors, your beliefs, and your thinking, you demonstrate, by example, the skills and knowledge they need to manage cultural environments. Jim Kouzes and Barry Posner,Kouzes & Posner (2002). in The Leadership Challenge, found that leaders should establish principles that guide people to reach their goals. Because a small shift or change could be overwhelming for some, helping them to set short, interim goals can help them to achieve larger goals. Modeling the way by identifying the barriers, being resourceful, and creating opportunities for your own success helps others to see their own abilities succeed. Take, for example, the case of Jaime and Anne:
Jaime is in her late 20s. She serves as the director of a civic engagement program in a nonprofit organization. Anne is in her late 50s and manages the program, reporting directly to Jaime. They’ve worked together for the past three years fairly well. They have their disagreements but overall have a healthy working relationship.
In the last year, the board of directors has changed the nature of the program to incorporate civic engagement and service learning principles. As a result, an increasing amount of volunteers in the program are college and high school students. Jamie notices that Anne has difficulty working with a younger generation of volunteers. She doesn’t respond to them the way she responds to volunteers who are in her age group. Sometimes, Anne will make side comments about the younger generations’ work ethics saying, “They’re so unreliable” and “I don’t know why they don’t just pick up the phone to talk to me. It’s like they don’t know how to leave a message on voicemail anymore.” She’s even said these comments to her 55+ volunteers, who readily agree about the generational differences.
Jaime knows that Anne needs to be able to work with volunteers of all ages and cultural backgrounds. She’s seen the negative impacts of Anne’s behavior. Many of the younger volunteers come to Jamie if they have problems or issues when they should be going to Anne who directly manages them. They’ve expressed that Jaime is “more like them” and understands them. Although Jamie doesn’t mind helping the volunteers with their questions, it’s taking her away from her role and responsibilities as a leader of the department. Additionally, it’s setting a tone for how Anne works and reshaping her job duties.
To resolve this, Jaime speaks with Anne about the issue. Anne doesn’t see a problem with how she’s handling the situation with younger volunteers. Jaime disagrees and at the end of the meeting, both agree to a plan that helps Anne to work more effectively with volunteers of any cultural background. Jamie and Anne work together to set goals that are achievable and work toward the long-term goals of the organization. Jaime finds opportunities to compliment Anne when she is successful and helps Anne to identify strategies that help her do her work more efficiently.
Jaime continues to work with Anne in the months to come. She’s patient and believes that Anne will be able to adapt; however, after two years, Jaime decides to let Anne go because the situation does not change.
It is important to recognize that there are times that no matter how much you try to model the way for employees and others, it does not work out to the benefit of the organization. In the example of Jamie and Anne, after 2 years of Jaime modeling the way and helping Anne, the progress was not significant enough to make the change that was needed. There was still resistance on Anne’s part. After much reflection and evaluation, Jaime decided to let Anne go. The cost of low self-efficacy affects not only Anne but also the program and the organization’s overall goals.
Support Others in Their Self-Efficacy Development
As any leader should, it is important to support your staff, co-workers, and the organization to strengthen their self-efficacy. You can do this in several ways:
• Verbally tell them that they are making progress.
• Have evaluation or reflection sessions about the progress.
• Provide them with the right resources.
• Tell them to keep trying and to sustain their efforts.
• Know when to give feedback and what type of feedback to provide.
If you are looking to develop your own self-efficacy, then you need to put in systems that will help you. For example, find the role models and proper support mechanisms to ensure you do not fail. Finding support is important because your support system helps to minimize your attention on weaknesses; they provide constructive feedback to help you develop professionally.
Emphasize Self-Improvement
Unfamiliar cultural interactions are challenging, and you should look at your success and failures as personal and professional development. There will be times when you will be involved in cultural misunderstandings, make “cultural bloopers,” or take part in a cultural conflict. This is just a part of the process of navigating through cultural terrain. When this happens, you need to focus on the value of self-improvement. Do not berate yourself over the mistake; learn to “learn and let go.” When it is an employee who makes the mistake, do not compare them to others; rather, set a standard for improvement within cultural interactions and help the employee to get there. Notice how Jodi felt about herself in the following case study:
Jodi is a Magnetic Resonance Imaging (MRI) technician. She’s been in the field for ten years and works with a variety of patients from different cultural backgrounds. One day, an African woman, Aziza, her son, Guleed, and her husband, Hussein, comes into the clinic for an MRI. The son accompanies his parents and interprets as needed because, although they understand English, they have difficulty speaking it.
Jodi calls the patient to the MRI room. Her co-worker, Melinda, assists her with the preparations and is with her in the room. Jodi prepares for the MRI by giving Aziza instructions, “You will lie down on the machine. You need to be very still or we have to start over.” Jodi then turns to Guleed and speaks slowly, “Can you tell your mother that she needs to be very still when she’s in there?”
Guleed understands and explains the MRI procedures to his mother. He then says to Jodi, “My mother has done this before. She had an MRI three years ago. She knows what to do.”
“Okay,” Jodi says. Again, her next instructions to Guleed are spoken in a slow pace, “Does she need medication to help her with staying still?”
Guleed shakes his head. “She’s fine. She’s done this before.”
Jodi then turns to Aziza and says very slowly, “If you need help or to call us, you push this button.” Her gestures to the family are overly emphasized when pointing to the call button. “Can you tell her to push this button if she needs help?” Guleed, looking more frustrated as the instructions are dictated, nods his head and explains to his mother.
After the MRI, Jodi courteously thanks the family and says, “You all did a very good job. Have a good rest of your day.” The family quickly walks out and Guleed gives a slight smile in response.
Jodi and Melinda return to their work, and Jodi says “That family was interesting. It was so nice of that boy to come with his parents to interpret, don’t you think?”
Melinda turns to Jodi and replies, “Yes, it was a good thing that he was there.” She hesitates and then says, “But you know, you probably didn’t need to talk like that to them.”
With surprise, Jodi says, “Talk like what?”
“You were talking really slowly to them. It seemed like they didn’t appreciate it. The son knew English very well and was fine interpreting and understanding what you told him.”
Jodie replies, “Oh. But in that class we took the trainer said we should talk slow and not use big words so they can understand us. That’s what I was doing. I mean, she probably didn’t know what I was talking about so I had to talk slow to help her understand.”
“Yeah, that’s true but you were really dramatic about it. They’re not deaf. They just have a harder time grasping the language.”
Jodi pauses and then says, “You’re right. How embarrassing! I hope they don’t think badly of me. I was just trying to get them to understand what they needed to do. Next time I’ll do it differently.”
Jodi tries to apply what she has learned in cultural competency training, yet she is not able to apply the learning in a way that is appropriate to different racial and ethnic groups. This is evident when her colleague, Melinda, informs her that she thought Jodi used the wrong cultural competency tools. Jodi’s instant emotional response was to be offended and to feel guilty for her intercultural mistakes. However, she realizes that her experience and mistake will only improve her ability to work better with different cultures.
Jodi can use the CI principles to help her in the following way:
Acquire: In this case study, Jodi has good intentions to be respectful of another culture. But what she is not picking up on are the verbal and nonverbal cues of her environment. If Jodi can identify what she did well and where she could improve, she can better assess her level of understanding culture in this situation. Jodi has worked with families of different backgrounds, but it seems as if no one has told her that she was unintentionally creating an uncomfortable environment for those families. To acquire information about culture that can be helpful to her in future situations she can start with recognizing what cultural facts and knowledge she may already have. For example, she speaks slower to this family so they can understand. Yet she needs to know that not all families need to be spoken to in this manner.
Build: If Jodi can take the knowledge she has, speaking slower in English can help those who are not English native speakers, and combine this with the knowledge that not all non-English speakers need to be spoken to in this way, then she will begin to build her awareness for when speaking slowly would be appropriate. When she does this, she is creating new information and making new sense of the cultural information.
Contemplate: Even though Jodi is familiar working with families of different cultures, she can always approach the situations with new lenses or perspectives. By asking herself what she sees and does not see in the situation, she can shift her mindset from one that treats all families the same to one that treats them as unique. Contemplation requires Jodi to reflect on her biases as well as the unintentional consequences that come about because of her need to be culturally appropriate.
Do: As she practices the strategies she creates for each family situation, she will learn what works and does not work for each family. She may even be surprised that she is adapting and changing her behaviors with every family she treats, even if the families share similar cultural backgrounds and interests. The more she practices and evaluates, the more she will reduce her need to be perfect in every cultural situation. Instead, she will learn that her mistakes become cultural lessons in practice.
Reduce Anxiety and Stress Related to Cultural Interactions
When we feel we are capable of accomplishing a goal, we have positive emotions. When we know that we do not have the abilities to accomplish the goal, our emotions and mood for the activity are less positive. How we feel can be a deterrent to our success by affecting our attitudes and perceptions of who we are and how we will achieve our goals. Our negative moods can create stress, anxiety, frustration, and fear—all which do not serve you in intercultural work. As a leader, you should help support strategies that reduce the stress and anxiety related to unfamiliar cultural situations. And, if you are the one who gets anxious, stressed out, or disinterested, you should find strategies that work for you. The following are some tips for reducing stress and anxiety related to unfamiliar cultural settings that can bring about a more positive outlook:
• Keep a stress journal. Use the journal as a way to track your physical and emotional responses to unfamiliar cultural settings. As you write out your feelings, you will begin to see common themes and patterns in your behavior. When you can identify what makes you stressed and how you typically respond, you can find the appropriate strategies to reduce your stress level.
• Keep a gratitude journal. When we are stressed and our anxiety is high, we often cannot see the opportunities and positive outcomes in intercultural relationships. Keeping a gratitude journal enables us to identify the pieces of the relationship or the situation that contributes positively back to our self-development, even though, at the time, we may think it is the worst thing to have happened. Writing down a few things you are grateful for in the situation helps to shift your mind-set and calm your physical and emotional state.
• Break your goal into smaller, manageable steps. For example, if you need to learn a new language and culture but it seems overwhelming, break that goal into smaller tasks over time. Do not take on more than you can handle. If the time does not allow for it, ask your supervisor for support and ideas to make it more manageable.
• Express your feelings and emotions in a healthy manner. For example, you need to be able to communicate your feelings and thoughts to your supervisor. Your concerns should be expressed in a respectful manner. If you do not share your concerns with your supervisor, you will build resentment and emotional clutter around the situation. If this continues over time, you build unhealthy habitual patterns and responses every time you are in unfamiliar territory.
• Be willing to compromise and let go. Working with cultures means that you have to be adaptable and willing to let go of what you know. You have to be flexible or else you are always going to have problems that frustrate, disappoint, and anger you.
• Stay calm and focused on the task. The more anxious you are, the more you visualize and paint a picture that creates more stress for you. According to Bandura,Bandura (1994). your stress level can impair how you function inter- and intrapersonally. Staying calm and focused helps you decrease your stress and anxiety.
• Recognize that you cannot control culture. Culturally intelligent leaders know that culture cannot be controlled. It is ever changing, never static. You have to recognize that there are times in cultural situations that you cannot anticipate, no matter how much you have trained, read resources, or lived in the culture. As in life, there are many things that are out of our control. We cannot expect that our intentions will always have the impact we envision it to be. This is why focusing on the things we can control, such as our adaptive responses to another person or culture, is better than stressing about what we cannot control.
• Be willing to forgive. People make mistakes. At times, people are not aware of what they have said or the implications of what they have done. When it comes to cultural intelligence, you have to be willing to forgive others both for what they are conscious and not conscious of doing, saying, or feeling. If you cannot forgive, you are going to have a hard time working with unfamiliar cultural environments.
• Keep your sense of humor. Working interculturally can be both tiring and exhilarating. There will be times when you make mistakes and feel disappointed for not picking up the cues or for not “knowing what to do.” Keeping a sense of humor about culture lessens the stress. You have to be able to laugh at yourself; otherwise, the challenges of cultural differences become too much to bear.
I once consulted with an organization that had a tool called “The Wizard.” This tool helped organizations to be more accountable and transparent in their use of charitable donations. They wanted to expand their tool to a diverse audience. In a session focused on thinking about how the tool could be more accessible, it struck us that, in one of the languages, the word “wizard” translated into “Shaman.” In this community, the shaman happens to be someone who is wise and connects with the spirit world. Can you imagine going into the community and talking about how “the shaman” will help you to be more accountable? We all laughed, and we also used this as an opportunity to discuss the challenges of accessibility.
5.07: Summary
• Interactions within cultures are based on a person’s sense of efficacy, which is their belief about their abilities to perform what is required in new cultural settings.
• Culturally intelligent leaders have higher levels of self-efficacy. They look at challenges as opportunities, they are resilient and persistent in their pursuance of the goal, they have higher confidence levels, and they are committed to finding solutions.
• Individuals who have low self-efficacy have lower expectations of themselves in new cultural settings, they lose interest and commitment under duress, and they focus on doubts and negative outcomes.
• Emotional intelligence speaks to the importance of self-efficacy in leadership; it points out the critical role self-efficacy has on managing one’s emotions, adaptability, and optimism.
• Mindfulness brings about creativity and innovation. It takes leaders “out of their boxes” and gives them a new way of perceiving themselves, their abilities, and their world.
• Mindlessness comes about through repetitive behaviors. Mostly unconsciously, a state of mindlessness can lead to learned helplessness.
• Research has shown that you can improve your self-efficacy, and the chapter highlights areas for leadership development. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/05%3A_I_Think_I_Can_and_I_Will/5.06%3A_Developing_Your_Self-Efficacy.txt |
George Herbert Mead (Mead (1925)). argued that individuals develop a self-concept that evolves throughout their lives as a result of interacting with their social world, which may include parents, teachers, and peers. Similarly, William Purkey stated that “self-concept may be defined as the totality of a complex, organized, and dynamic system of learned beliefs, attitudes and opinions that each person holds to be true about his or her personal existence.”Purkey (1988). These interactions help individuals form a perception of who they are based on expectations from, and responses to, their social environment. Our perceptions are stimulated by internal and external factors. These factors can create intense emotional responses, which impact our willingness to learn and our choice of action—they guide individual behaviors. The following example demonstrates this idea of self-concept and how it manifests in one’s behaviors.
Like many teenagers in the United States, Karen was required to take a foreign language course at her school. She chose to learn German because relatives on her mother’s side lived in Germany, and her family was planning a visit in the summer. Unfortunately, Karen’s few months of German class were not fun. She had a teacher who was very strict in her lesson plans and grading of the students. Additionally, Karen fell behind in the class work due to an after school sports injury; she was out for two weeks. When she returned to class, her teacher called her out in front of other students when she didn’t know the correct vocabulary terms and proper responses. She didn’t feel motivated to be in class and learn German.
When summer arrived, her family went to Germany as planned to visit their relatives. Karen’s parents had been excited about her foreign language choice, and her relatives knew she was taking a German culture and language course. During the stay with the relatives, Karen tried to practice her German but stopped trying after her relatives told her, “You need to improve your German.” The next year, her family visited Germany again, and her relatives question her about her German language skills. Upon hearing her speak, they told her again, “You’re not there yet. You need a lot of improvements.”
Twenty years later, Karen works for a financial company that has a location in Germany. Karen’s supervisor tells her that she will need to relocate to Germany for two years; she thinks that with Karen’s great interpersonal skills, she would be able to help the success of the project. Upon hearing this, Karen becomes anxious and uncomfortable. She makes excuses for not going, and her supervisor is confused. Karen has been an outstanding worker and her actions are puzzling and surprising.
Karen’s self-concept has contributed to her self-efficacy. The expectations of her teacher, her family, and her relatives to learn a new language is too much for her to handle. The responses she receives are not what she wants or needs to hear to help her improve her German language skills. As a result, she withdraws from learning the language and culture. She develops a self-concept that may consist of any of the following:
• I will never learn the German language and the culture.
• I do not have the ability or skills to learn a new language.
• It is easier if I just do what is comfortable for me.
• I cannot make mistakes or people will lose their confidence in me.
These beliefs and attitudes surface when her supervisor asks her to relocate to Germany. The negative memories and experiences she had become barriers to her success and self-efficacy. She feels anxious, and her behaviors are seen as strange.
Developing a Self-Concept
There are three general understandings about how a self-concept is developed. First, a self-concept is learned. As Mead indicates, a self-concept gradually emerges early in one’s life and is constantly shaped throughout life by one’s perceived experiences. This means that a self-concept is learned: it is a social product of one’s experiences. The perception of one’s self-concept may differ from how others perceive that person, and it is different during every life stage. When a person is presented with an experience that differs from the self-concept he or she has developed, the person sees the experience as a threat. The more experiences that challenge the self-concept, the more rigid the self-concept becomes. Generally, an individual will try to overthink, overgeneralize, or rationalize the experience so as to reduce the emotional havoc it creates.
Second, a self-concept is organized. Most scholars agree that individuals develop a self-concept that has stable characteristics in order to maintain harmony. Our self-concept is orderly: it categorizes our experiences and “fits” them in a way that will make sense to our development. It discards experiences that present different beliefs and values because it cannot be placed in a categorical way. It is our self-concept that tries to resist change, because the changes disrupt the stability of one’s personality. Let us say you hold a very specific belief, such as, “English is the primary language of this country and everyone should learn to speak and write it. There is no reason to have billboards and signs in other languages.” The more central this belief is to your self-concept, the more resistant you are to learning new experiences and to adapting your belief.
Third, a self-concept is dynamic. Self-concepts are actively shaped based on one’s experiences, which means that they are dynamic. The self-concept can be seen as a guidance system directing your behaviors to match up with your beliefs. I often hear employees in organizations say, “My company does not do what it says it will do around diversity and inclusion. It says one thing, and its actions are completely the opposite.” At an organizational level, the company may perceive itself differently, defending its self-concept. There is a conflict between this perception of who they are versus what others think they really are. Complaints from employees will be rationalized, or bended, to fit the self-concept of the organization and its leaders. In psychology, this is called cognitive dissonance, that is, one’s justification for one’s beliefs even when the facts clearly demonstrate the opposite.
The following case study illustrates the self-concept in action.
Joe leads a Public Safety department in Garden Grove, a suburb located just outside of a large urban city in the Midwest. He’s lived and worked in this city all his life, and generations of his family have made Garden Grove their home. They settled in the area when it was just farmland and have seen it develop over time into a bustling city of 128,000.
Garden Grove, like other suburban cities in the United States, has seen an increase in the number of non-white residents. A large number of Asian residents move into the city because they are attracted to the educational system and quality of life the city offers. This change has made the city more racially diverse than ever.
Joe sees the visible differences on a personal and professional level. In his neighborhood, 25% of his neighbors are Asian Indian, 10% are Vietnamese, and 10% are Chinese. He’s had problems with his neighbors; what used to be a quiet neighborhood is now a festival every week. His neighbors have lots of visitors who park up and down the side street, their children running around without any parental guidance. Once, he held a party to celebrate his son’s graduation from high school, and his relatives and friends had to park two blocks away because of his neighbor’s party.
At work, he’s pressured from his director to hire more people who “reflect the community” that Garden Grove has become. From volunteers to paid staff, he’s had to work through policy changes and make accommodations for who he hires. He disagrees with his director that he should hire someone just to make a quota, and besides, he can’t find anyone who has the skills or the experience for the department jobs. Although he loves his job, it’s not what it used to be. He’s increasingly unmotivated to go to work. It seems that all he does these days is attend training sessions on diversity. What’s happened to his passion for public service?
As the director, you have noticed the changes in Joe. You know it has to do with the new vision of the organization to increase racial and cultural diversity as part of the city’s strategic vision. To help Joe manage his self-concept, think about the following questions: What do you think is Joe’s self-concept? What are the beliefs that are being challenged? When evaluating this case study, there are several items that are important to note:
• Joe has a long history of family traditions and roots in Garden Grove.
• His experiences and knowledge of Garden Grove span generations.
• Joe and his family are accustomed to interacting with people who are Caucasian.
• He has a belief that his neighborhood was a “quiet” place to live, but it is now disrupted because of the new neighbors, who are not so quiet.
• He has a belief that the parties thrown by his neighbors are so large that he considers them festivals.
• He does not understand the collective nature of the Asian Indians, Vietnamese, and Chinese neighbors in his neighborhood.
• He believes that one should be hired on the basis of merit and skill rather than filling a quota.
All of these items are some examples of Joe’s beliefs that form his self-concept. In the case study, you can also identify what emotions and feelings he has related to his self-concept, such as his discomfort with nonwhites. Identifying emotions is useful for understanding how the self-concept develops to make the person feel comfortable.
Developing a Self-Understanding
One’s self-concept is developed throughout one’s lifetime and has an impact on behaviors and choice of action. How have you come to understand yourself over time? How has this understanding led to the choices you make? One way of gaining knowledge of who you are is through personality assessments. There is a plethora of assessments and inventories, and I describe three that I have used successfully with diverse audiences. I have found that these three assessments are excellent tools for building cultural intelligence and leadership.
• Reflected “Best Self” Exercise helps individuals to identify their strengths and talents. The exercise requires that you seek out and request feedback from significant people in your life—siblings, parents, friends co-workers, colleagues, mentors, supervisors, relatives, and so on. Once you collect the information, you create a picture of your “best self.”This exercise was found by The Center for Positive Organizational Scholarship at the University of Michigan, Ross School of Business, http://www.bus.umich.edu/Positive/POS-Teaching-and-Learning/ReflectedBestSelfExercise.htm
• Via Institute on Character is a nonprofit organization that was founded in 2000 by Dr. Martin E. P. Seligman and Dr. Neal H. Mayerson. The organization provides, free of charge, a survey (VIA Survey of Character) that measures 24 character strengths. VIA stands for “Values in Action,” and the survey can be used to help improve one’s performance and well-being.See the organization’s website for more information: http://www.viacharacter.org/
• The Enneagram Institute provides a personality assessment to help you discover and understand your personality type. The institute suggests that there are nine basic personality types, and these types serve as a framework for understanding oneself and working with others.See the organization’s website for more information: http://www.enneagraminstitute.com/ | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.01%3A_Concept_of_Self.txt |
Parker Palmer wrote, “When leaders operate with a deep, unexamined insecurity about their own identity, they create institutional settings that deprive other people of their identity as a way of dealing with the unexamined fears in the leaders themselves.”Palmer (1998). What Palmer speaks to is a level of dissonance that often occurs often in human interactions, particularly with leaders.
Cognitive dissonance is a state of discomfort that humans experience when one of their beliefs, ideas, or attitudes is contradicted by evidence or when two of their beliefs, ideas, or their attitudes come into conflict with each other. Dissonance makes people feel uncomfortable and “is bothersome under any circumstance, but it is most painful to people when an important element of their self-concept is threatened—typically when they do something that is inconsistent with their view of themselves.”Tavris & Aronson (2007), p. 29. A famous case in cognitive dissonance comes from the work of Leon Festinger, who described the workings of cognitive dissonance that occurred in a group setting.
Festinger and his associates studied a group that believed that the earth was going to be destroyed by a flood on a certain date. This belief led group members to gather in the same location and pray; by doing so, they believed they would be saved. In the end, there was no flood and no end of the world. So what happened to the members? For the group members who were really committed to the belief (basically, giving up their homes and jobs), when the flood did not happen, these individuals had a large dissonance between their beliefs and the evidence they saw. Because of this large gap between their beliefs and the evidence at hand, they were more likely to reinterpret the evidence to show that they were right all along. For example, they would say that the earth was not destroyed because they came together to pray. While these individuals justified their beliefs, the others recognized the foolishness of the experience and changed their beliefs or actions.
Using this example to guide our thinking about cultural intelligence, we can see that culturally intelligent leaders must be able to address the dissonance between their beliefs, ideas, or their attitudes and behaviors. When leaders fail to see the connection, they are not really walking the cultural intelligence they talk. Some leaders will justify their beliefs even when the evidence eventually contradicts their belief systems. And rarely do we see organizational leaders change their beliefs or actions to align with what they say they will do around diversity and culture.
Learning and Dissonance
Dissonance can also occur when new learning or ideas are presented that conflict with what is already known. For example, an employee is required to attend a diversity workshop. During the session, the employee hears ideas that contradict, or come in conflict with, her belief about the topic. This employee already has certain knowledge about cultural diversity that she brings to the workshop, and because she is especially committed to her own knowledge and belief system, it is more likely that the employee will resist the new learning.
You can tell when a person is struggling with dissonance when you hear statements like, “Why can’t people who come to this country be more like us,” or “Why do we have to take these classes,” or “I have to change my belief (or what I do) just to accommodate someone else?” More often than not, when the new learning is difficult, uncomfortable, or even humiliating, people are more likely to say that the learning or workshop was useless, pointless, or valueless. To admit one’s dissonance would symbolize that one has been “had” or “conned” into believing something different.
If all this sounds familiar to you, or resonates with what is going in your organization, you are not alone. Our behaviors are very much rooted in beliefs that are not completely explored within a working environment. Organizational leaders do not clearly articulate how to think about and practice cultural intelligence. The result is a failure to implement and practice cultural intelligence that corresponds with the belief systems. Organizational leaders—especially those specifically working on diversity initiatives—need to identify the points of dissonance that occur in their organization and among their staff. Leaders should pay attention to this dissonance and how it is being expressed.
Larger Gaps, Larger Dissonance
According to cognitive dissonance theory, the more important the issue and the larger the gap between the beliefs, the greater the dissonance among people. This is critical for leaders to understand because culture is a very important issue within an organization. There are inherently large gaps in beliefs on a personal, team, and organizational level related to this culture. Individual beliefs about power and privilege—as they relate to gender inequity, race inequity, generational differences, ability and disability, sexual orientation, religion, and so on—need to be explored in organizations and among leaders. If dissonance is not discussed, leaders will continue to employ workers who (a) feel uncomfortable talking about culture and diversity, (b) continue to behave in inappropriate ways, (c) are accepting of culture on the outside but do not align diversity with their beliefs, and (d) feel that all they need are the “right tools” or the “right answers” to be culturally competent.
Without careful attention to exploring the stories of dissonance, leaders allow their organizations to bury their inclusion blind spots. Blind spots in cognitive dissonance describe the things you cannot see because they are hidden or because you choose not to see them. We are unaware of our blind spots because our focus is directed toward other things or we are distracted from what needs to be done. Blind spots can lead to underestimating or overestimating our cultural abilities and to truly understanding what needs to be done regarding culture and diversity. Regardless of the talent that is recruited, the accomplishments or progress that is made, or even how much money is poured into diversity initiatives, these blind spots can cause leaders to miss opportunities that bring about positive, transformative change and innovation.
Given this information, what can leaders do about the cultural dissonance within their organizations? First, leaders must have the courage to be open to the possibilities that their beliefs, or the organization’s beliefs, are not aligned with their actions and behaviors. It takes courageous leadership to not maintain the status quo and to explore the stories that give root to organizational and individual beliefs. Second, leaders can, and should, explore the dissonance by asking themselves the following questions:
• What are my organization’s beliefs about culture?
• What dissonance is present in our beliefs and our behaviors?
• What gaps (in recruitment, within policy, and in intrapersonal interactions) are created because of the dissonance?
• How is this dissonance stopping us from truly understanding culture?
In cultural intelligence work, it is critical that you recognize your self-concept to understand your blind spots. As a leader, it is your responsibility to help others recognize their self-concept and the role it plays in intercultural interactions. It is essential for you to understand that people will often choose to stick to their beliefs (even if it no longer serves them) to alleviate the emotional stress that reorganizing a self-concept requires. They would rather fend off the perceived threat than create learning opportunities out of these experiences.
Finally, it is important for leaders to work with employees to explore employee dissonance. Learning to work with, and understand, cultures is not the sole responsibility of leaders; it is the responsibility of everyone within an organization. Because leaders are in the positional power to promote and support the work, it is the responsibility of the leaders to help their employees uncover their blind spots. With clear sight of these blinds spots, organizations can turn them into an advantage. By doing so, organizations can find significantly greater possibilities that expand and deepen intercultural work than previously imagined.
Adapting and Modifying Behaviors
When we learn something new, we change our perspectives of our world, the way we interact with others, and our behaviors. We also learn when our behaviors are inappropriate and, hopefully, learn not to repeat them. We do this by adjusting our behaviors so that the situation does not occur again. We act differently based on previous consequences. If our behaviors resulted in a positive impact, we would continue the behavior. Take, for example, the following story about New Zealand’s soccer team, “All Whites.
After landing from a long flight from Austria, New Zealand’s soccer team, All Whites, heads to the South African stadium for their first day of training. They are met by a “smelly fog” on the field, making it difficult for players and coaches to breathe and see. One player comments on the smell and smog saying, “You could tell [it was smoky] as we came in on the bus. You could taste it, breathe it on the bus. It’s something that’s a bit different for us and something else to adapt to on tour.” The management team debates canceling the training and in the end decides to have players stretch their legs and get some exercise. Local South Africans on staff are confused at the entire ruckus and can’t understand why a team would stop playing because of a “little smog.” The players and team management can’t understand how anyone could play under such conditions.Lammers (June 8, 2010). The Dominion Post. Bizarre first training hit out for All Whites. Retrieved from http://www.stuff.co.nz/dominion-post/sport/football/3785307/Bizarre-first-training-hit-out-for-All-Whites
Learning a new pattern of behavior requires modifying small behaviors that add up to a complex behavior. Learning new patterns can be difficult but the motivation to modify and change can be transformational. Kevin Cashman said that positive change means letting go of our old behaviors and allowing change to be our teacher.Cashman (1999), pp. 87–88. As leaders, we must recognize our own capacity to change—that we have what it takes to make a change. To make a change, you need to believe you are capable of performing the behavioral change and that there is an incentive to change. Similarly, Margaret Wheatley said this about the human capacity to change and transform,
Viability and resiliency of a self-organizing system comes from its great capacity to adapt as needed, to create structures that fit the moment. Neither form nor function alone dictates how the system is organized…The system may maintain itself in its present form or evolve into a new order, depending on what is required. It is not locked into any one structure; it is capable of organizing into whatever form it determines best suits the present situation.Wheatley (2006), p. 82.
When making changes to your behaviors, there are three questions to ask to help initiate the change. Bridges (2004).
What is changing? To understand change, you must be clear about what you want to change in your cultural interactions. Then, make it your intention to change and carry out the change. Finally, your change must be linked to your motivation for changing. You will need to ask, why is it important that I make this change? How will this change my future interactions with this individual or cultural group?
What will actually be different because of the change? Because transformative change in cultural interactions can be hard, the ability to visualize the end result or outcome of the change can help move the situation forward. Visualization requires an articulation for what the desired result and outcomes look like. Setting clear expectations for getting to the desire result can help motivate you to making the change.
Who’s going to lose what? In any cultural shift you will need to ask yourself, What beliefs and values might I have to let go? Why is it hard to abandon your beliefs and values? How well have these values and beliefs served you? What are the barriers they create for your future? Consider the following case study of two individuals’ behaviors in relation to one other:
Jose is from Costa Rica and Mary is from Great Britain. They work together in an international company located in the United States. Mary notices that whenever Jose talks, he always inches closer to her personal space. She’s extremely uncomfortable when this happens and always takes steps back to give more physical space to the conversation. When she does this, Jose comes closer. One time, Mary was backed up to a work place counter and Jose didn’t even notice!
Imagine that Mary and Jose work for you, and Mary has approached you with her concerns. To help Mary find a solution to this situation, use the following table to help you to think through some important questions; then, look at the second column as one possible perspective or thought about the question. Finally, fill in your perspective and thoughts.
Self-concept does not necessarily mean that you have the knowledge and skills to be where you need to be. Because change and transitions are emotionally and psychologically taxing, making a connection between the behavior change and the outcomes can help to ease the transition. In some cases, if an individual is not responding to the change, rewards and reinforcers are used to increase a behavioral response. Even adding a compliment can increase a person’s behavior toward However, if a person does not know what fuels his or her self-concept, then the challenge in making a transition will be more difficult.
Table 6.1 Changing Cultural Behaviors
Questions One Perspective/Thoughts Your Perspective/Thoughts
How do Mary and Jose view personal space? How does this impact their behaviors? Mary feels a great need for personal space. As a woman, perhaps she feels a greater need for this space. Jose does not see a problem with the personal space. Maybe getting closer to her is one way of relating to her.
What are the adaptive behaviors needed in this situation? Mary and Jose need to understand that everyone has different ideas of what personal space means. It may be helpful for Mary and Jose to talk about personal space issues, especially what it looks like for both of them. Perhaps Mary is the only person who feels uncomfortable and the only one to have brought this up. Maybe others do not feel the same way.
What, if anything, will Mary and Jose lose if they change their behaviors? Through conversation, Jose and Mary will discover that their idea of personal space is related to their cultural upbringing. They might be resistant to the change in the beginning, because they see it as “their individual cultures or their national cultures.”
What will be gained from changing the behaviors of Mary and Jose? Mary and Jose will have a greater understanding for working together. Mary can focus on what Jose says instead of focusing on his body language toward her, and Jose can learn to control his own body language and to read that of others. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.02%3A_Cognitive_Dissonance.txt |
In The Spirit Catches You and You Fall Down, Anne FadimanFadiman (1998). described the story of a Hmong refugee family, the Lees, and their intercultural interactions with doctors in Merced, California. The story is about Lia Lee, the second-youngest daughter who is diagnosed with severe epilepsy. Within the Hmong culture, epilepsy is not described in the same way that Western medical doctors describe it; epilepsy is described as qaug dab peg or “the spirit catches you and you fall down.” According to animism, the foundation for Hmong religious beliefs, both good and bad spirits surround us. Epileptic attacks are seen as the ability of an individual to temporarily join the spirit world. This is seen as honorable because the spirits have chosen that person to communicate with them.
The language used by Hmong and Americans to describe their understanding and knowledge of what was happening to Lia can be referred to as linguistic relativity. Linguistic relativity was first developed by Edward Sapir and Benjamin Lee Whorf, and is known as the Sapir-Whorf hypothesis,Whorf (1956). or the principle of linguistic relativity. It describes the idea that language influences the perceptions and thoughts of people, thus affecting their behavior. In Hmong culture, there is no word for “epilepsy”; instead, the word is associated with the animistic worldview of the Hmong, which serves as a philosophical, religious, and spiritual guide to operating one’s life. The only way to describe epilepsy is related to this world view of spirits. In Western medicine and science, rationality, logic, and objectivity are important—scientific words and definitions are not abstract; rather, they are concrete.
Sapir and Whorf argued that individuals are not aware of the influence of language, and it is only when moving between cultures that individuals become aware. A commonly cited example of linguistic relativity is the example of how Inuit Eskimos describe snow. In English, there is only one word for snow, but in the Inuit language, many words are used to describe snow: “wet snow,” “clinging snow,” “frosty snow,” and so on.
The following case study further explains the idea behind linguistic relativity:
Carol serves as a program director for a local nonprofit in the Washington DC area. Her organization has received a federal grant to implement employment training and resources to serve the large and growing Somali population in the area. The grant requires her organization to track outcomes and the impact of the training program on participants’ lives. Each participant is required to attend an exit interview session conducted by a staff person.
Carol creates a survey that is both qualitative and quantitative to measure the impact. Questions relate to the participant’s experience in the program and ask participants to rate their level of agreement to statements. Table 6.2 "Survey to Measure Program Impact" shows sample questions from the quantitative survey.
Pattie serves as the interviewer for all the sessions. She reads out loud each statement and given the responses, checks the appropriate box. She notices that during the first round of interviews, participants are unsure how to respond. They are unclear about the levels of rating given to them: strongly agree, agree, disagree, and strongly disagree. Additionally, some of the statements are confusing. She tries to explain the difference but is unsure how to describe the statements differently. She’s frustrated because she’s concerned she’s not getting the right information, and she knows that it must upset the participants.
Table 6.2 Survey to Measure Program Impact
Statements Strongly Disagree Disagree Agree Strongly Agree
I know how to use the Internet to find a job.
I am able to put together a resume for a job.
When I find a job I like, I know how to respond to the job posting.
I know the appropriate questions to ask a potential employer in interviews.
Carol and Pattie discuss what they could do differently in the survey or process to help the Somali participants understand the questions. Unfortunately, they do not have an employee on staff that can translate. In the end, Carol and Pattie decide to change the process and the language barriers in the interview. They decide that pictures may help illustrate a level of agreement. They also agree to take out the “big words” or words that would further confuse the participants. They also changed the rating scale to reflect: yes, no, and maybe. The revised survey had the following questions.
I know how to use the Internet to find a job.
I know how to create a resume for a job.
When I find a job I like, I know who to call in the company.
I know what I can and can’t ask in interviews.
Now imagine that you are Carol’s boss and you have been updated about this situation. What suggestions do you have for Carol and Pattie as they continue their work?
There are a number of ways to think about the work. In cultural intelligence, understanding how to adapt your behavior is critical. The following are questions that you should think about in order to help Carol and Pattie adapt their behaviors:
• What emotions come up for you in this work?
• Are the emotions negative or positive? How does it fuel your work?
• What is the influence of language on evaluation?
• What body language do you notice? What does it tell you? How can it be helpful to our work to identify verbal and nonverbal cues?
• What are we doing that works?
• What do we know does not work in this project?
• What are the learning opportunities for all?
Asking these questions is a start toward continuing the good work that Carol and Pattie have already begun. As the two move forward in their work and learn more about what works and what does not work, they will learn to ask and reflect on questions that are inclusive to other cultures. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.03%3A_Linguistic_Relativity.txt |
Our behaviors are communicated both verbally and nonverbally. Culturally intelligent leaders pay attention to both cues. Earley et al.Earley, Ang, & Tan (2006), p. 83. noted, “When we meet strangers from other cultures for the first time, their outward appearances and overt behaviors are the most immediately obvious features, not their hidden thoughts and feelings.” I experienced this when on my first trip from the United States to France.
In my mid-20s, I went to France with my family to visit my uncle on my mother’s side. As we boarded the flight and found our seats, my father and I had challenges finding an overhead space for our bags. Because we did not want to hold up the line of people who needed to pass us to get to their seats, we needed some assistance. I explained to my father in our native Hmong language that there were flight attendants who could assist us. Not too far from us, I spotted a flight attendant and said to my father, “I think he could help us.”
My father, who was distracted and gently being pushed to the side by much taller passengers making their way to their seats, could not see where the attendant was. I said, while pointing in the direction of the attendant, “Dad, he’s over there.” My father looked up and, at that same time, I looked over at the flight attendant. We made eye contact, and because the plane was bustling with passengers, rather than calling out for assistance, I signaled with my hands for him to come over to us.
The next thing I knew, the flight attendant came over. I was so ecstatic to see that he was going to help us that what he said took me by surprise. “In our country, we don’t point our fingers at other people. It’s rude.” Because his voice was loud, other passengers turned to look at what was going on. Completely embarrassed, I said, “I’m sorry. I didn’t know.” He replied curtly, “Don’t ever do this [points his finger at me] again.”
“Okay. Thanks for letting me know,” I responded with an apologetic tone. It was certainly not my intention to point directly at him, or to call him to us in that manner.
After settling in our seats with the plane on its way to France, I found myself getting emotional about the situation. He thinks I’m rude for pointing? He’s rude for not even letting me explain. Besides, I didn’t point my finger at him. I was just pointing in the direction he was standing. And, what’s his problem that he doesn’t know pointing fingers is also rude in America? Does he think I’m NOT from America?
I describe the emotions I felt as my “emotional hijack” moment, which is when the thalamus in the brain bypasses the “thinking brain” (cortex) and sends signals directly to the amygdala (emotional brain); I took out my journal and deconstructed the situation. It was my way to slow down and understand what happened; it was an opportunity to think through my thinking.
From this experience, I was reminded of the impact verbal and nonverbal communication has within intercultural interactions. And that, sometimes, the intention of your communication does not have the impact that you hoped for.
Silence
Edward HallHall (1990). found that silence serves as a critical communication device and that it is viewed differently in different cultural contexts; he called these cultural contexts high-context and low-context cultures. Societies around the world fall into one or the other cultural context. Hall explained that in high-context cultures, pauses and silence reflect the thoughts of the speaker whereas, in many European countries, silence can be uncomfortable. Aida HurtadoHurtado (1996). found that women of color used silence and outspokenness as a mechanism of testing knowledge and acquiring new knowledge about social environments. She argued that women of color use silence as a strategy for obtaining and reconstructing knowledge, and the usage of outspokenness compliments silence in “knowing when to talk and just exactly what to say is especially effective if individuals are not expected to talk.”Hurtado (1996), p. 382.
As culturally intelligent leaders, we have to recognize the moments of silence and their meaning. As an educator in the United States, I often come across students in my classroom and training who are from high-context cultures. The majority of them do not speak unless specifically called out to provide a response; this differs from my students who are from low-context cultures, such as the United States, who constantly raise their hands and have something to say. The following is another example of silence and talk:
A few years ago, Dr. Osmo Wiio, a communication scholar from Finland came to the United States as a visiting professor. While riding a public bus to the campus, a woman sitting next to him struck up a conversation, intending to be friendly. “I see by your clothes that you may be a European. What country are you from?” Wiio replied curtly, trying to discourage further conversation: “Finland.” He held his newspaper so as to cover his face. But his fellow passenger stated, “Oh, how wonderful! Please tell me all about Finland.” Professor Wiio felt very angry that a complete stranger had initiated a conversation with him. In Finland, a cultural norm discourages striking up conversation with strangers in public places.Rogers & Steinfatt (1999), p. 151.
Cultural norms can also vary within a country. In some parts of the United States, a stranger attempting to initiate a conversation would be treated brusquely, while, in other parts of the country, the same stranger would be treated kindly.
Self-Disclosure
Individual behaviors also differ based on a culture’s notion of self-disclosure, the degree to which individuals share personal information with others. In general, collectivist and high-context cultures do not disclose much, while individualistic and low-context cultures are more self-disclosing. Take, for example, the following case study of a market research company that conducted surveys for their client, a health clinic:
ActiveSearch, a market research company in the Midwest, was contracted to conduct follow up surveys with patients of a local health clinic. The clinic wanted to improve the quality of services and care provided and especially wanted to receive feedback from their African, Southeast Asian, and Latino patients. The phone surveys were short, no more than ten questions that asked about the quality of service, reason(s) for visit, timeliness, and ability of staff to respond knowledgeably and appropriately. Phone surveyors made calls to 1000 patients who were seen by the clinic within a six month period. To the surprise of the market research company, they encountered what they perceived in the beginning as “resistance” to respond to the satisfaction survey. Results from the surveys were disappointing because less than 70 African, Latino, and Southeast Asians participated compared to 638 white patients who responded. After careful evaluation and reflection, the company realized their error. African, Latino, and Southeast Asians patients did not want to share their health concerns with the surveyors; they were suspicious of the company. Whereas, white patients were accustomed to taking satisfaction surveys and did not express concerns over how the information would be used.
ActiveSearch mistook the refusal to participate as “resistance.” The company did not realize that the African, Latino, and Southeast Asian groups they surveyed had cultural norms that spoke to keeping information within certain circles. The idea of sharing one’s health issues is considered a private family matter in these groups, and trust was a large issue as well, as they were not sure what the information would be used for. Many respondents may even have thought they would lose their insurance or health care if they gave out information. Understanding the different belief systems that underline the cultural norms of self-disclosure would have been helpful to the business.
Maintaining Relationships
In their communication behaviors, collectivist cultures emphasize the importance of maintaining relationships. They will shape messages that will not be offensive, shaming, or cause a person to lose face. To a person from an individualistic culture, however, the message may be unclear, indirect, and ambiguous. The following case study provides an example of this:
Savitha and Mary are new coworkers having worked together for the past six months. Mary feels that she would like to get to know Savitha better. She invites Savitha and other colleagues to a barbeque at her house. Savitha declines, saying, “Thank you but I have a family commitment that day.” Mary understands and says, “Of course. Hopefully we can do something another time.” Over the next year, Mary invites Savitha on several occasions to join her for coffee, dinner, or social events—sometimes with colleagues and sometimes just the two of them. Each time that Mary suggests a time to get together, Savitha responds that she is busy. Savitha says “no” because she also believes that her relationship with Mary needs to stay at a professional level, but she doesn’t tell this to Mary. Mary’s beginning to think that Savitha does not like her, and if that’s the case, why doesn’t she just come right out and say that?
In this example, Savitha is maintaining what she perceives as a harmonious relationship with her family, which Mary does not understand. From a collectivist culture, Savitha wants to ensure that the family relationship dynamics are not disturbed. Additionally, she wants to preserve the harmony of a professional relationship with Mary; rather than disrupt the flow of that relationship, she chooses to communicate this indirectly to Mary. She does not want Mary to lose face or take offense, yet the results are exactly the opposite of what Savitha expects. Mary thinks she is evasive. Both Savitha and Mary can learn about the different ways that different cultures express relationships and maintain healthy relationships. If both were aware of each other’s cultural norms, they could adapt their behaviors.
The Concept of Face
An important aspect of interpersonal relationships is the concept of face. “Face” is seen as one’s public image in social contexts, and this concept is very important in Asian cultures that have a collectivist identity. These societies are concerned with saving face, or how they will appear to those around them. Public criticisms that can lead to a person losing face may harm the person’s identity and image, especially within their families and communities. Losing face can lead to deadly consequences, as in the following example:
In August 2007, Mattell was forced to recall over 900,000 plastic toys due to excessive amounts of lead in the paint. Later that month, Zhang Shuhong, the CEO of Lee Der Industrial in China, the manufacturer of the toys, committed suicide after China temporarily banned the company’s exports. A Chinese newspaper said that a supplier, Zhang’s best friend, sold Lee Der fake paint that was used in the toys. “The boss and the company were harmed by the paint supplier, the closest friend of our boss,” the report said. It continued that “in China it is not unusual for disgraced officials to commit suicide.”
Later that year, in September, Mattel’s Executive Vice President for Worldwide Operations, Thomas Debrowski made a public apology to the Chinese government saying, “Mattel takes full responsibility for these recalls and apologizes personally to you, the Chinese people and all of our customers who received the toys. It is important for everyone to understand that the vast majority of these products that we recalled were the result of a flaw in Mattel’s design, not through a manufacturing flaw in Chinese manufacturers.”Selko (2007). Industry Week. “CEO Of Toy Manufacturing Company Commits Suicide”. Retrieved from http://www.industryweek.com/articles/ceo_of_toy_manufacturing_company_commits_suicide_14790.aspx
As this case illustrates, this situation even led to Mattel trying to save its face with the Chinese government and its people.
Time
Time is an important value dimension of culture and, as a result, impacts the behaviors of people. As discussed in Chapter 2 "Understanding Culture", time is regarded in some cultures as punctuality, while, in others, time is more relaxed and is viewed as contributing to the building of relationships. The following case study illustrates the notion of time and the behaviors of cultures based on their interpretations of time.
Tim, a white man, manages a production department in an American private business. Many of his assembly line workers come from the Southeast Asian and Asian cultures. Whenever his employees had a problem, they would want to talk and discuss the project at length. They not only wanted to understand the problem but they wanted to keep harmony in the organization. They would come back to him several times even after the problem was resolved. For this manager, the problem had a quick solution: he provides the solution and his employees should comply. However, he doesn’t understand why his employees keep coming back to him about the issues. He’s annoyed at the amount of time it is taking to manage the process.
Tim and his employees have been raised with different notions of time. Tim thinks that time is associated with efficiency and effectiveness. To him, when an issue is discussed and a solution is provided, he believes there should be no further discussion. For his employees, the act of coming back to the problem is not to find more solutions; rather, it is to continue to develop a relationship with the manager—it is to ensure that the relationship is harmonious and in balance. For them, it is a check-in point in the relationship.
LeBaronLeBaron (2003). noted that cultural understanding of time can impact conflict management and negotiation processes. As an example, she described a negotiation process between First Nations people and the local Canadian government. She wrote,
First Nations people met with representatives from local, regional, and national governments to introduce themselves and begin their work. During this first meeting, First Nations people took time to tell the stories of their people and their relationships to the land over the past seven generations. They spoke of the spirit of the land, the kinds of things their people have traditionally done on the land and their sacred connection to it. They spoke in circular ways, weaving themes, feelings, ideas, and experiences together as they remembered seven generations into the past and projected seven generations forward.
When it was the government representatives’ chance to speak, they projected flow charts showing internal processes for decision-making and spoke in present-focused ways about their intentions for entering the negotiation process. The flow charts were linear and spare in their lack of narrative, arising from the bureaucratic culture from which the government representatives came. Two different conceptions of time: in one, time stretches, loops forward and back, past and future are both present in this time. In the other, time begins with the present moment and extends into the horizon in which the matters at hand will be decided.LeBaron (2003), pp. 7–9.
You can probably guess the result of this meeting. Both sides felt misunderstood and neither was happy with the results. Their world views, including the language used in the negotiation processes, originated from separate paradigms. Because neither of the groups understood the dimension of time and the influence of language in their behaviors, it led to decreased trust between them. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.04%3A_Behavior_and_Communication.txt |
Successful adaptation requires cultural strategic thinking, motivation, and mindfulness. In this way, cultural intelligence principles are interconnected and interrelated. You must be able to think about your thinking, contemplate it, and then adapt it based on your findings and reflections. Behaviors, whether appropriate or inappropriate, must be identified and defined in objective terms. You have to know exactly what behaviors are reoccurring and why they need to be changed. By doing so, you can describe the things you say to yourself as well as the situations or behaviors that you are imagining. You can, and should, talk about the evaluation statements you make about yourself. The use of cultural strategic thinking and mindfulness can help you to identify your behaviors and thought patterns.
Table 6.3 "Identifying Behaviors and Thought Patterns" is a case study of Gillian, who has been asked by her supervisor to lead development for a new service in her organization. Observe how she analyzes the situation in order to identify her behavior, the thoughts she had, and the emotions or behavioral outcomes she experienced.
Next, Gillian decides to find a way to manage her distressing thoughts and emotions. Because her anxiety, fear, and nervousness do not serve her as a leader in this work, she needs to identify more desirable thoughts. When she does this, she is less likely to have negative emotional responses that can lead to depressed moods and behaviors. To reframe her behavior, she will ask three questions:
Where is the evidence that contributes to my thoughts? Gillian will use this broader question to further explore her confidence, her ability to manage the team, and whether she has facts that support her thought pattern.
Are there other possibilities to this situation? Gillian will use this broader question to explore what she is not seeing in the situation and whether the facts presented are true, or if there are other explanations.
What are the implications of my behaviors? Gillian will use this broader question to understand how she feels, whether the feelings help or hinder her, if the feelings create a positive end result, and what consequences would occur because of her resistance to change.
Table 6.3 Identifying Behaviors and Thought Patterns
Situation Thoughts Emotions or Behaviors
My manager placed me in a work group to lead development for a new service in our organization. Working with the team requires that I make several trips to different parts of the world to speak with different team members. I have never worked with any of the individuals before and have not worked in a multicultural team. I don’t know if my responses and interactions with them will be appropriate. I don’t know what to expect because we are a new team. I’m not even sure I know how they want to interact with me. Do they think I will be controlling, demanding? Should I be more participatory than usual in my leadership style? I don’t want to mess this up. I feel anxious. I am not as confident in myself and my abilities. I feel nervous about the whole thing. I feel like I’m losing control.
When Gillian is able to identify the negative or inappropriate behaviors and identify the behaviors she wants, she is then able to respond and adapt appropriately. Sometimes during the adaptation and adjustment period, it is helpful to recite self-statements to cue you in the direction of the positive behaviors you want to express. Peer support can also be helpful in changing minds, because your peers can help point out in the situations where you revert back to old behaviors. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.05%3A_Changing_Behaviors_Changing_Minds.txt |
Gardner wrote in Changing Minds that to “capture the attention of a disparate population: create a compelling story, embodying that story in one’s own life, and presenting the story in many different formats so that it can eventually topple the counterstories in one’s culture.”Gardner (2004), p. 82. Stories can, and do, shape culture in positive and negative ways. They help shape processes such as orienting new employees; they can serve as symbols that reinforce norms such as cubicles for employees and suites for executives; or they can create organizational heroes and heroines such as employee stories of leaders that go the extra mile.
Storytelling is an excellent way for leaders to garner staff involvement, bring new clients to an organization, or paint a vision of an organization’s future. In its essence, storytelling is about how you communicate your vision, your goal, or your objective to listeners—in other words, storytelling can help you get your point across. Telling different stories can initiate different actions from story listeners, eliciting stories that speak to their behaviors and their experiences.
The impact of storytelling in organizations has become increasingly important because stories are memorable, no matter how poorly or well told they are. Emerging research studies show that storytelling has a tremendous affect on an organization’s capacity to grow and manage change. Organizations in transition that use elements of storytelling demonstrated improvements in team performance and in overall project management. Although the research literature on storytelling is limited, the importance of storytelling is being noted on an international level. Stories, like Gardner expressed, are powerful tools, and when the right story is told, leaders can take the proper action needed for intercultural work.
Storytelling Unites Cultures
Storytelling is a unique strategy for socializing members into your organization and encouraging them to abide by cultural norms and values. This technique is especially helpful in guiding new members in understanding company values and beliefs. New employees will have assumptions about what to expect in their first day on the job. They often create their own realities, through their own stories, of what the organization is to them based on the behaviors, actions, and attitudes seen, heard, or felt during this initial phase. For current employees, storytelling emphasizes the important aspects of an organization’s culture that you want them to value and demonstrate in their work. Perhaps these aspects have been previously missing from the organization, and by using storytelling techniques, you automatically bring people together by creating and sharing a common story.
As leaders, it is important to cultivate stories that have meaning for employees and to guide members back to core values of the organization. For example, a principal of an elementary school may tell the story of a student who emulates her teacher in order to reveal how much impact teachers have on children. An executive director of a nonprofit organization will tell a story of the organization’s founder by describing the founder’s personality, character, and vision to motivate current employees in their work. The choice of the stories, the characters chosen, the timing of the story, and the details emphasized will create memorable stories that stay within the minds of organizational members. Leaders can create organizational stories that will be passed on throughout the life cycle of their organizations.
Culturally intelligent leaders can shape intercultural understanding by utilizing several methods that address the underlying assumptions, beliefs, and values of its members; however, this is not an easy task. As indicated, culture oftentimes consists of unconscious behaviors, values, and assumptions that develop over time and changes may occur as new associates enter into the organization. Too often, leaders will neglect to solicit information from their employees in building the organization’s culture and values. This fallacy, often unintentional, can harm the organization and affect its leadership.
The following exercise will help you to identify stories that support intercultural interactions and understanding of culture in your place of work. By reflecting on these exercises, you will learn what stories drive your organization and what ones might be discarded:
1. In the space below, list the types of jokes about intercultural work that are told in your organization. If you know the words to the jokes, write them down.
2. Write down all the common phrases that are spoken in your organization related to intercultural understanding such as, “Here’s another meeting we’re required to attend on diversity,” or “I’ll work with this person but only because I have to.”
3. Think of one common story that has been told in your organization. It could be a story of why your organization thinks diversity and culture is important to the work or why certain people leave the organization.
As you take a look at your responses, think about the following questions:
• What are the common stories in your organization?
• Are the stories generally positive or negative?
• What is your role in creating these stories?
• As a leader, what stories, if any, can you change in your organization?
• What steps, if any, will you take to change your organizational stories?
6.07: Summary
• Changing behaviors requires cultural strategic thinking and mindfulness in order to recognize which behaviors are inappropriate and which are desirable.
• Self-concept is critical to one’s adaptation. Self-concepts are developed over time, they are dynamic, and they are organized.
• Cognitive dissonance can interrupt one’s self-concept. Dissonance between one’s self-concept and what is heard or observed causes one to feel uncomfortable, anxious, fearful, and, in the learning process, makes a person less likely to learn the new information.
• Adaptation of one’s behaviors requires management of the internal change process and one’s responses to it. Knowledge of your behaviors during change or transitions can help you to identify the emotions and thoughts you have that are counterproductive to your ability to adapt.
• Linguistic relativity is the idea that language shapes world views and also shapes behaviors. Words, and the understanding of words, take on many forms in different cultures; words may be understood differently in different cultures.
• Cultures communicate in different ways, and, as a result, the behaviors of people are different. It is important that, as a leader, while paying attention to the behaviors, you recognize the intention of the communication versus the impact.
• To change one’s behaviors, you must learn to change your mind. This requires the ability to think in a culturally strategic manner and to be mindful of your thoughts and behaviors. Once you identify the situation, the thoughts you have about the situation, and the emotions you feel in the situation, you have a greater chance of changing the behavior.
• Storytelling is a strategy to use when changing behaviors. Stories can unite people of different cultures in recognizing core organizational values. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/06%3A_Adapting_and_Performing/6.06%3A_Changing_Minds_Through_Storytelling.txt |
In the previous chapters, you have been presented with the three principles of cultural intelligence: cultural strategic thinking, motivation, and behavior. This chapter provides case studies that are a combination of real life stories shared by clients and colleagues I have worked with over the last 7 years as well as cases from national and international newspapers. Names of organizations and individuals have been replaced and situations have been altered to conceal their identities. of leaders and managers who must find solutions to working through intercultural problems and situations. Each case study is followed by an activity to help you apply your understanding of the cultural intelligence principles; then, it is followed by a list that outlines sample ideas related to the questions in the activity. The following are your instructions:
• Read the case studies.
• Answer the questions in the activity section.
• Review ideas.
07: Cultural Intelligence in Action
Victor is the head of a division in a state agency. He has been in his management position for 15 years and has worked his way up to his current position. Throughout his career, he has seen many people leave and join the department. He has stayed because he enjoys public service and working with familiar faces in the agency. He also knows that he brings his many years of experiences in a public agency to the table when solving problems. His personality fits the working environment of a state agency; he likes working with the familiarity of rules and procedures.
Victor is proud of his service, but he is really looking forward to his retirement, which, for him, is not coming soon enough. Within the last few years, lots of changes have occurred on a department level that is also changing much of the familiar procedures, rules, and norms that Victor has been accustomed to during his 25 years in the department. Some of these changes include hiring younger staff, reorganization of job responsibilities, performance plans to increase staff competencies and skills in new areas, and recent layoffs to help balance the budget.
As part of his attempt to make his mark on the division, and to bring in past experiences that he thinks can be of value, Victor proposed numerous ideas for the division at a staff meeting. His staff—which, in recent years, has become increasingly more diverse in demographics and cultural backgrounds—suggests improvements and changes to his ideas. They are not so sure that his changes are the most appropriate given the overall strategic directions of the department. Furthermore, they are not sure how they can implement strategies when the ideas call for outdated resources and technology. Some of the younger staff members are more vocal and mention recent trends and practices in strategic thinking that could be more beneficial to accomplishing the division goals.
Victor views these suggestions as attacks directed at him and as resistance on the part of the staff. He feels like every time he makes a suggestion, he is thrown a curveball from one of the younger staff members. Why is this happening to him now? He knows he has to manage this. He cannot let this type of dynamic go on for an additional five years—or could he?
1. What cultural assumptions fuel Victor’s perspective as a leader of a state agency?
2. Where does Victor’s motivation to lead come from?
3. How would you describe Victor’s self-concept and the influence of it on his leadership?
Reflection
Victor has several cultural assumptions that can be broken down into different cultural levels: individual, team, organizational, and national cultures. His assumptions and beliefs may include any of the following: working hard will get you to the top, everyone must obey rules and procedures, and you must have experience in order to know what you are doing in a job. This could be why he feels attacked when his younger employees make suggestions. It is also important to note that Victor may have been raised in a homogenous culture that did not allow him to interact with others who did not share his same cultural values and belief. Victor can benefit from learning about his self-concept and how his values contribute to his management. By doing so, Victor helps his team to understand him more.
CI Model in Action
• Acquire: Victor has a lot of knowledge about working in public sector organizations. His tenure in a state agency makes him very familiar with this type of culture. But he lacks knowledge about what is unfamiliar to him, particularly around generational issues. He knows what areas of his work frustrate him; now, he needs to acquire information that help him understand why it frustrates him. To improve his cultural intelligence, Victor would need to develop a plan that helps him to become more familiar with the different cultures in his work team.
• Build: To build his knowledge in cultures, Victor can develop strategies that help him connect his current cultural knowledge to the new knowledge he wants to gain. For example, he identifies that the characteristics of a younger generation are new to him. He can put together a plan where he monitors his communication with the staff to gauge whether he is really understanding what is going on. It is important here that when he builds new knowledge, he is aware of the skills he has and what he lacks when working with a younger generation.
• Contemplate: Victor’s self-efficacy is an issue in this cultural situation. He has a few years left before retirement and considers giving up. He needs to make a shift, changing his attitude from one of frustration to a positive perspective. He can do this by visualizing the positive end results and reminding him that he can and should keep trying. He needs to put in place a plan where he can monitor his internal motivation toward the issue.
• Do: It seems in this situation that change will be difficult for Victor because he is set in his ways. Victor can be mentored and coached to think about change and its impact on his situation by asking himself: What is changing, What will be different because of the change, and What will he lose? Using these three questions he will learn to identify the change and behaviors that need to change, the potential results of the change, and what beliefs and values he will need to discard in the process. By identifying specific areas of change, Victor can transition better. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.02%3A_Case_Study_1_-_Resistance_to_Change.txt |
Julia, who is 26 years old, recently graduated from the University of Chicago with her master’s degree in social work. She is a confident young woman who is used to making quick decisions, and she greatly values her independence. She graduated at the top of her class and, throughout her course of study, was known by her peers and professors as a “go-to person” for resolving conflicts and finding strategic, innovative approaches to social work. She is highly motivated and passionate about social justice and social change issues, particularly those involving poverty and housing.
She has high expectations in her career as a social worker and has found a job working with a local nonprofit organization that provides transitional housing to people who are homeless. Her boss, Joanne, holds her in high regard, but now, in her second month of the job, Julia is increasingly annoyed by her boss’s constant micromanagement and questioning of her decisions. “Come to me before you make a major decision. I don’t want you to move so fast on your own,” Joanne says.
Julia asks, “Have I made any mistakes so far?” “No,” Joanne retorts, “but I feel that you need to check in with me before you move on with some projects. You’ve only been here for two months and there’s a lot of stuff you still need to learn.”
“Well, tell me what they are. I’m eager to learn everything so I can do my job better,” Julia replies.
“I don’t think you’re ready yet. There’s a lot to learn about this job. Believe me, I was like you, too, when I was younger, but over the years I’ve learned that it takes time and patience to do this work. It’s fast paced and working in this field can be emotionally draining. We just can’t afford to make mistakes when we do this work.”
Julia cannot believe what she is hearing. Here she is, eager and motivated to take on more work, and Joanne says that it is too overwhelming. She thinks, “What kind of work environment is this that won’t let me use skills and knowledge?”
This week, Julia is furious. She worked on a slide presentation for a major donor and prepared a report about the progress of the organization’s clients, for which Joanne commended her. Nevertheless, she was told bluntly that she could not be a part of the donor meeting. “This is ridiculous,” Julia thinks. “I’m moving on. I’ll stay here until I get something better, but I sure am going to start looking around.”
1. What beliefs and values “root” Joanne and Julia to their self-concepts?
2. What suggestions do you have for Joanne and Julia when working with a person of another generation?
3. How would you suggest Joanne and Julia use the cultural intelligence principles to resolve this intercultural situation?
Reflection
Julia believes she is a fast learner, and she has a high level of confidence. She wants to quickly move up the ladder but feels that Joanne, her manager, is creating barriers. Joanne does not feel this way and believes that she knows best, given her experiences in the industry. Both Joanne and Julia have beliefs about who they are and what they are capable of doing. Additionally, they both are making assumptions about each other, which leads to their behaviors. It would be helpful to both individuals to conduct an exercise that explores their behaviors, the thoughts that accompany the behaviors, and the emotions they feel.
CI Model in Action
• Acquire: Joanne is in a formal position of leadership in this case study. As a leader who wants to be culturally intelligent, Joanne would seek to understand what experiences she has had in the past that contribute to her thinking about individuals like Julia. She needs to make the connection between this information and the new information about what she wants to experience related to generational culture. It would be helpful for Joanne to think about how she feels and what she might suspect Julia to feel in their interactions. Identifying emotions and feelings can serve as a great source of feedback to help Joanne comprehend the full picture of the situation.
• Build: To improve her cultural intelligence, Joanne can seek out a mentor who has worked with individuals like Julia. In CI work, it is important to be able to talk through cultural situations, particularly your plans and goals related to working with different cultural groups. In this situation, a mentor can help Joanne to identify the pieces of culture that she may not be picking up such as Julia’s high expectations of herself, her ability to get things done in an informal work setting, and her working style preference.
• Contemplate: Joanne, in this case study, thinks that Julia is very capable to carry out projects and tasks. However, she can do more to help build her own self-efficacy as well as Julia’s, thus improving both their cultural intelligence. It is more effective if Joanne schedules weekly evaluation and progress sessions with Julia. In this session, Joanne can help Julia to understand specific outcomes and expectations as well as take the opportunity to mentor her. Developing her cultural intelligence would mean that Joanne comes to these meetings prepared to provide the right type of feedback and recognize when to provide this feedback.
• Do: Joanne is able to quickly point out to what Julia’s blind spots are in their interactions. But does Joanne see her own blind spots? In this component of CI, Joanne can and should evaluate her own behavior, including what she may not see because she is too focused on whether Julia will make a mistake. Her ability to adapt rests on her acknowledgement of what makes her uncomfortable when Julia performs well. Does she hold a belief or attitude about how work can be completed? Or who can do the work? | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.03%3A_Case_Study_2_-_Young_Confident_and_Moving_too_Fast.txt |
Kalia works in a large business, managing a diverse team of eight individuals. Two of her employees are in their early 20s, two in their 30s, three in their late 40s, and one in her late 50s. Four members of her team are Caucasian and the other four are Hispanic, African American, Asian, and African. Her younger employees are fairly new, having been there for less than two years. Most of her team members have worked with the organization for 5 to 10 years, and her most senior staff has been there for 25 years, 10 years longer than Kalia has been in her leadership position.
Generally, team members are cordial to one another on the surface, but Kalia knows that there are tensions among some of the staff that have an impact on the success and productiveness of the team. She is aware that one of the younger employees, Robert, is frequently frustrated that his Hispanic co-worker, Ana, defers authority and decision making to others in the team. In conversations with him, she discovers that the younger employee feels Ana should express her opinions more often. Robert’s frustration results from his beliefs that everyone on the team should be able to contribute in a shared, democratic process. He feels that when Ana defers her decision making to others, she is not being accountable as a team member.
Margaret, a senior member of the team has picked up on Robert’s comments and feels that he is disrespectful of Ana’s working style. She has mentioned to him that it could be a “cultural thing” and that he should learn to adapt his behavior and working style to better meet her needs. In response, Robert mutters, “Whatever. You don’t know anything about us.” Responses like this have led Margaret to believe that he is disrespectful of her knowledge and tenure in the organization.
Frankly, Kalia is tired of managing people’s personalities. She feels that people should just learn to adapt to each other’s working styles. Even though she believes this, she also believes that a good leader has to unite the team, no matter their differences and working styles. This year, she has made it a goal of hers, and of the team, to resolve these intercultural issues. But given her previous attempts, she does not have high hopes for a successful outcome. The last time she tried to resolve intercultural team issues, she felt like a complete failure. She is concerned about the employees’ responses to this next attempt. In fact, every time she thinks about that meeting, she flinches. She just did not have the skill sets to facilitate the conversation in their last meeting. She wonders if this next try will progress her team in any way or whether it will just be another failure.
1. How do you describe Kalia’s self-efficacy?
2. How does Kalia’s self-efficacy impact her leadership?
3. What strategies do you recommend to Kalia to help her improve her cultural intelligence?
4. What suggestions do you have for Kalia in leading her staff to be a culturally intelligent team?
Reflection
Kalia works with a multicultural team, and each member has his or her own individual differences. In a situation like this, it would be helpful for Kalia to explore her motivation and self-efficacy for managing multicultural teams and resolving intercultural conflicts. Her self-efficacy can, and does, have an impact on her leadership. If her employees sees that she is not confident or able to resolve conflicts, they may disregard the positional power she has as a leader. Because it seems as if she is overwhelmed, it would be helpful to her to break down her goal of creating a culturally intelligent team into manageable, small goals. She can also help others to recognize the basics of cultural differences in the workplace and the positive ways in which differences can be used to ignite their work.
CI Model in Action
• Acquire: As a leader, it is important for Kalia to understand the types of individual and team culture that are present in her work place. Her frustration about her team is a result of not knowing what to do based on her limited perspective of culture. Broadening her viewpoint to understand the value dimensions of culture such as language, power, authority, and gender can help her to make more sense of the situation. As Kalia learns this new information, she can evaluate her progress by identifying points in her interactions where the value dimensions appear and whether she has accurately assessed the situation. Understanding the particulars about culture will help her to grasp the cultural dynamics at play.
• Build: Resolving cultural conflicts can be overwhelming, especially to someone, like Kalia, who wants to avoid it. In this situation, Kalia will need to help resolve the conflict among team members. She can do this in two ways: first, by helping team members to understand their individual working styles, and in this case, taking the members that have the most conflict aside for discussions. Second, she can help them understand how individual cultures contribute to a team culture by describing the type of team she wants to build. She can mediate the conflict by herself or bring in an outside mediator.
• Contemplate: Kalia’s anxiety and self-induced stress is a barrier to her success as a leader. She believes she does not have the skill sets to facilitate future meetings, and her thoughts are focused on this point. She cannot shy away from the situation, thus it would be helpful to Kalia to create smaller action steps for her team and herself to meet the larger goal. She would need to stay calm and focused on the task.
• Do: Kalia’s internal motivation will be a huge assistance to her managing the situation. She knows she does not have the skill sets to facilitate the next meeting, but she can find ways to build her skills, or she can bring in an outside person to help her mediate. If she chooses to facilitate the meeting on her own, she will need to reflect and identify the skill sets she would need. She can do this by first identifying the thoughts she has related to the situation and the behaviors that accompany the thoughts. In doing this, she may find out that she has the skills to facilitate but needs more confidence. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.04%3A_Case_Study_3_-_Building_a_Multicultural_TeamIs_it_Worth_it.txt |
It’s been 6 months since Kolab was hired to lead a large, nonprofit organization called, International Education Center (IEC), which provides international education and information to the citizens of a Midwestern state. The organization provides opportunities for individuals to learn about different cultures and to gain an understanding about their role as citizens of the world. It does this by connecting the people of the state with visitors from all over the world in order to meet and learn from one another.
Prior to the job at the IEC, Kolab directed national programming and services for the Office of Refugee Resettlement (ORR) in Washington, D.C. Before her job at the ORR, she worked for an international relief agency and traveled extensively throughout Southeast Asia and Africa, working in the organization’s field offices, managing its daily operations.
Kolab, born in Cambodia, fled with her parents to the United States as refugees during the regime of Pol Pot and the Khmer Rouge (the followers of the Communist Party who ruled Cambodia from the 1975-1979). Her experiences growing up as a refugee fuel her motivation and passion for international work. It also shaped her expectations and working style. She is known to her colleagues as a “go-getter” and a “high performer.”
The board of trustees thought Kolab’s international experiences and goal-oriented, achievement-focused attitude was just what they needed to expand the organization on a national level. The previous president, Hanh, did not have the strategic thinking and vision to move IEC, even though she was very effective at building relationships throughout the state. After 10 years with IEC, Hanh decided to step down from her leadership role. This gave the board of directors an opportunity to hire someone like Kolab who can challenge employees and push the organization to reach its financial and fundraising goals.
Since Kolab’s hire, employee productivity and motivation has decreased. Staff used to enjoy coming to work, talking with one another, and planning programs and services for the community. Now they come to work because “we need a paycheck,” and they accomplish their tasks because “Kolab told me to do so.” There is no enthusiasm for the mission of the organization and the vision for the new work that Kolab and the directors created in a strategic planning meeting. A couple of times, when Kolab passed employee cubicles, she heard comments like, “She works us all like we don’t have a personal life,” “She’s so impersonable,” “I miss just chatting with people,” and “Hanh was never like this. She always made time to talk to us.”
Just last week, Kolab had a staff meeting, and the majority of staff sauntered in late. Throughout the meeting, they gave her blank stares, and, as soon as the meeting was over, they quickly left. Kolab is tired of the staff attitudes and behaviors. “The culture of this organization can’t operate the way it used to. I am determined to change it,” she thinks to herself.
1. How does Kolab’s self-concept influence her ability to lead?
2. What cultural value dimensions does the organization operate under? What about Kolab?
3. What cultural intelligence strategies do you recommend for Kolab and her employees?
Reflection
There are several issues here that Kolab needs to work through. First, Kolab has a specific leadership style that she likes to use. Her style is task- and goal-oriented, and is influenced by her upbringing. Her beliefs and her attitude is exactly what the board wants, but it is drastically different than the leadership style and organizational culture that is familiar to the employees. Second, Kolab wants the culture of the organization to move toward accountability, goals, and achievement; this is not to say that the organization was not goal-oriented before. Kolab’s vision for the organization’s goals, and how to get there, is a departure from what the cultural norm dictated in the past. Third, the staff has a self-concept that was developed as a result of Hanh’s leadership influence. They are feeling a dissonance between their self-concept and the new one that Kolab wants to enforce. Kolab would need to address all these areas and find strategies that help to keep her staff motivated during this time of change.
CI Model in Action
• Acquire: There are multiple levels of culture at work in this case study, particularly how individual cultural differences are expressed and interpreted. Kolab has an approach to work that differs from her employees; most of the approach is based on her personal experiences and history as a refugee. As a leader practicing cultural intelligence, Kolab will need to take a look at her self-concept and how it differs or corresponds with her staff. She can do this in two ways: first, by exploring her own personal history and second, by getting to know her staff as individuals. The knowledge she gains about herself and others will bridge her understanding of individual cultural differences and how they are expressed in an organization.
• Build: Kolab was hired because she is a “go-getter,” which typically means that she is achievement focused and oriented. Her staff interprets this as “impersonable.” To build an understanding of cultural differences, Kolab can build into her personal development plan ways to observe and listen to her staff. As an observer, she can pick up on verbal and nonverbal cues in her environment, thus helping her pay attention to her surroundings. By actively listening to her staff, she will learn how to adapt her behavior appropriately for the situation she is in.
• Contemplate: Kolab has a high ability to be resilient, which she developed as part of her personality and individual culture because of her experience as a refugee. This will be helpful to her in staying positive about the situation. However, one of the things she could improve on is her ability to gauge the emotions of her staff during their interactions. She is not accurately perceiving the thoughts and emotions, thus she is unable to handle the relationships in a way that is appropriate.
• Do: Kolab is trying to change the culture of the organization. As a leader, she needs to recognize that cultural shifts can be difficult, and it is her responsibility as a leader to help her employees make the changes successfully. She can help change cultural behavior through the use of stories. She can strategize this in different ways. She can set time for people to share the stories of the “old culture” and what they would like to see in the new culture. She can, using the power of words and language, share stories of herself, her vision, and where she would like the organization to be. She can combine her stories with the stories of her employees to create a unified story. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.05%3A_Case_Study_4_-_A_New_Leadership_Culture.txt |
Diane is the president of a public relations and marketing company that is in its 10th year of business. The company has a wide range of clients in the government, in private businesses, and in the nonprofit sector. It provides media strategies, designs and develops media campaigns, and advises companies with their marketing plans.
Recently, she negotiated a contract with a local nonprofit organization interested in creating a media campaign to address domestic abuse and violence issues in disadvantaged communities. The nonprofit provides transitional housing, mental health services, and counseling and education to women and children seeking safety from their abusers. Residents are primarily women and children, of which 87% are African American, 10% are Hispanic, and 3% are Asians.
The nonprofit wants to reach out to the Hispanic and Asian communities. They want to provide information and education, and create awareness in the communities about their services. Felicia, the executive director, described to Diane what they have already done as an organization and the challenges they have encountered. She identifies these challenges as English language barriers, trust issues working with an organization not in their community, and different ways that the cultures respond to domestic violence and abuse issues. Felicia wants a campaign that will break these barriers and give the organization an opportunity to begin working with Hispanic and Asian communities.
Diane’s company has never worked on a media campaign such as the one presented to her. Although they have done campaigns and advised on strategies in the social services field, the topic of domestic abuse and violence, especially in Hispanic and Asian communities, is new to her and her employees. She is not worried about reaching the African American community, since she is from that community and has been successful in creating a variety of strategies and campaigns.
She knows that her employees will need to do some research before creating media messages that speak to the Hispanic and Asian markets. She is up for the challenge and thinks this project will expand the company in a new and exciting direction. In addition, it will help her staff improve their knowledge and work with the diverse communities within their city.
1. How can Diane and her employees use the idea of “self-concept” to help them in their work?
2. What cultural value dimensions should Diane and her employees be aware of when working with Hispanic and Asian communities?
Reflection
Diane knows that there is culturally specific information and knowledge missing in her organization that could help the business execute a media campaign. Using cultural strategic thinking, she can outline the outcomes of what she wants to achieve by looking at the gaps. Diane’s team can also use Hofstede’s cultural value dimensions to gain an understanding of each cultural group. By doing this, they can learn about the nature of power, relationships, and identity that exists in each group. They may find that one cultural value dimension takes more precedence than others in a cultural group. As a result of their cultural strategic thinking, they will come to learn about themselves as an organization and as individuals. When they do this, they will be better prepared to serve the client and the community.
CI Model in Action
• Acquire: Diane and her team can acquire cultural knowledge by identifying what they currently know and what they would like to learn. For example, if they know the communities they need to reach have language challenges, the team can describe what they would like to learn to overcome those barriers. Based on this first piece, the team can develop strategies to bridge the gaps between their knowledge. As they implement the plan, they can monitor and evaluate the success of the strategies.
• Build: It may be helpful to Diane and her team to create an advisory group of people from the communities they would like to reach. A group like this can provide them with peer learning opportunities and offer guidance in the project. Additionally, they can build their cultural intelligence by attending local events or talking to people from the communities they will market to. This provides them with an opportunity to check their assumptions and gather cultural information and facts.
• Contemplate: Diane seems ready to address the challenges, thus indicating that she is motivated and confident that herself and her team will end up successful. To keep their spirits high, the team can identify moments of success from past projects as well as identify current successes. Creating environments where her team feels successful in their job and accomplishment of goals will help Diane and her team to stay positive and focused. Doing this helps to increase their levels of self-efficacy and mindfulness.
• Do: As the team performs their strategies, their focus must be on cultivating respectful relationships with the communities. Diane and her team will need to pay attention to how relationships are developed as well as how relationships are interpreted within the communities. Understanding this helps them shape messages that are not offensive or shaming. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.06%3A_Case_Study_5_-_Marketing_the_Right_Messages.txt |
“Did you see last night’s primary?” Scott says to his staff during their morning coffee break as a team.
“Yeah. McAllister is going down! That ‘lefty’ annoys me. Talking about big government and ways to spend our hard earned money. No one in their right mind will vote for him. I’ll be celebrating when he loses come November,” Joe notes.
Scott replies, “If this liberal trend keeps up we won’t have any more freedoms. None of us will have jobs when big government steps in.” He sees his colleagues nodding their heads enthusiastically and hears echoes from his team, “Yep, that’s right.”
Scott notices that Amber, who he hired as a sales assistant to the team, is quiet. Maybe she is one of them, he thinks. “Hey Amber, you’re kind of looking quiet over there. What are you, red or blue?”
Amber is a bit hesitant. This is her first professional experience since graduating from college 6 months ago. Most of her teammates are in their mid 40s and have been working with the company for 10 years or more. She does not want any ill feelings, but she also does not agree with the language that is used and the conversation. She certainly does not want to create a bad image of her to her boss. “Well, I don’t think it’s about big taxes. I just don’t like the views of the new GOP candidate,” she says, carefully.
Scott quickly replies, “That doesn’t matter. If you’re voting liberal you’re going to bankrupt our country, and that’s it.”
Amber is taken back by the fierceness in her boss’s tone of voice and decides she will not participate in conversations like this anymore. However, in the next couple of months, her team finds ways to comment about her political views. They have even nicknamed her, calling her “Lefty.” She finds it disturbing that every time she speaks up about her viewpoints, her team instantly fires back with a counterargument—Scott included. When she has gently brought up the issue to her team, they laugh and say, “We’re just joking. Don’t be so sensitive, Lefty.”
Over time, Amber’s motivation and passion for her work decreases. She has become more guarded in her comments, and, at times, she argues back with just as much passion as the others. On the surface, the team gets along but the tensions impact their work together. Amber notices it but is afraid to say anything to Scott. She decides she wants to find another job—it is just easier that way.
1. What values and beliefs shape the behaviors of the sales team?
2. How is Scott’s leadership behavior impacting the team?
3. As Scott’s supervisor, what suggestions or course of actions would you take with Scott?
As a leader, Scott needs to evaluate his self-concept and the impact it has on the team’s culture. Having awareness for how he learned his belief systems and the ways in which the beliefs and attitudes influence the team environment can help Scott to build a more inclusive team. As a leader, he needs to build all areas of his cultural intelligence (CI) including helping his team to understand their ability to work with different cultural situations. If they do not, they isolate anyone who is a part of their team that does not hold the same political beliefs.
CI Model in Action
• Acquire: First, he must determine the gaps in knowledge that he and his team members have related to different political beliefs. Many of his team members operate from one particular belief system, which they now consider a team characteristic and norm. Using cultural strategic thinking, he could assess the team’s understanding of culture, the gaps in knowledge, and create a vision or goal for what they would like to achieve around cultural understanding.
• Build: A useful exercise for the team would be to help them change the types of questions they ask each other. Making the shift from judgment to learning can provide them with a different perspective. For example, rather than ask a judgment question like “Are you with us or not?” Scott and his team can ask learning questions such as, “Help me to understand why you agree with the other candidate.”
• Contemplate: Using mindfulness techniques, the team can evaluate how the political conversations and belief systems “box them” into a specific way of thinking about their worlds. This would require that they are active listeners and observers of the conversation, suspending their judgments of other beliefs and norms. It would serve them well to also learn how to manage their emotions and be able to adapt their behaviors by recognizing the emotions of others.
• Do: Finally, it would also be useful if Scott and his team took part in an exercise to identify the behaviors that are disruptive and inappropriate. Once the behaviors are called out, they could assess the thought patterns that support the behaviors and the emotions that arise because of the behaviors. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.07%3A_Case_Study_6_-_On_Opposite_Political_Sides.txt |
Community Action and Development (CAD) is an economic development center located in a small town a few miles outside of Fargo, North Dakota. Lori has served as its president for the past 10 years. The organization is a resource and business development center that brings local, regional, county, and community leaders together to partner on economic growth strategies for the region. Over the years, the organization has successfully created business financing programs, small business incubation, and new jobs, and it has established career and employment services to support local and regional business retention.
Having lived in North Dakota all her life, Lori has noticed a visible cultural change in the area. With several universities and colleges in the area that attract a diverse student body, an increasingly growing population of immigrants and refugees, and a large number of Native Americans, Lori knows that CAD will need to think differently about its work and who it serves. Leaders from different cultural communities have already approached the organization about potential initiatives to help develop business programs for their groups.
Lori knows that the diversity of changes can only be of benefit to North Dakota. She has read reports by the state demographer and has researched population changes in the United States, and she feels that CAD must make strategic decisions to embrace and involve the different communities in the area. If they time it right, CAD could be seen as a leader in developing services and programs that meet the needs of immigrant and Native American populations. Not only that, the labor shortage that North Dakota has seen in recent years, due to an aging population, could be addressed if the center worked on developing a new generation of workers.
Although there are many challenges to this work, there is one significant challenge that Lori is most concerned about. Her board of directors and many leaders in the community are fearful of the demographic changes. People are most concerned about illegal immigration as well as the perceived loss of German and Scandinavian culture. Lori has brought her ideas to the board; each time, she has been told, “We have to be careful with this issue” and “We’re doing just fine with our programs.” The board chair has even told Lori directly, “We have to respond to our constituents’ concerns and right now they don’t feel this is an issue they want to tackle. Let’s focus on them and their businesses.” Lori argued, “But, the new immigrants are our constituents too! We can’t ignore them. And, we haven’t done all we can to help bridge trust and understanding between ourselves and the Native American tribes here. We can’t keep going in this direction when the fact is that our community is changing.”
Lori has recently learned about cultural intelligence (CI) as a tool in business. She wants to introduce the idea of CI to her board and staff. She thinks it will be useful for them to understand the cultural shifts the community is undergoing and to recognize their values and beliefs. What suggestions do you have for her as she implements the CI principles in her place of work?
Reflection
Lori knows that she has to be careful when talking to her board of directors. There is already tension about cultural diversity issues and lack of awareness of the changing demographics. Many in her town feel threatened and do not pay attention to the changes. Lori has several challenges ahead of her, but there are several things she can do to make progress toward her goal:
CI Model in Action
• Acquire: She can use her experience and research around data collection to demonstrate the different ways in which the community is changing. Using data enables her to bring concrete facts to the table. Additionally, she can evaluate the board’s understanding of culture and how cultural differences are played out in the community.
• Build: Lori has the opportunity to find allies and supporters of her goal who have positional power or influence with board members. She can also find members on the board that can sway or influence others to a different perspective. These strategies can help move her closer to her goal and help the board recognize the importance of cultural changes in the community.
• Contemplate: She can help her board build their self-efficacy. Because they fear the ambiguity that change brings, she can develop systems or processes that enable her board to build their self-confidence. Additionally, if the board feels any anxiety or stress related to the cultural changes, she can help create a positive environment, gently reminding them of their successes when working with similar cultural situations.
• Do: An exercise to identify cultural changes, the results of the changes, and what can be lost or gained because of change would be helpful to this organization. Through this process, board members can specifically identify and articulate where their resistance lies. Additionally, Lori has the task of painting a different picture of change for the board members that are resistant. She will need to select her words carefully and be mindful of how she communicates and responds to board members. She can adapt her behavior and how she communicates to be less threatening to board members who fear change. Paying attention to the verbal and nonverbal cues she receives from the board can move her one step closer to her goals. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.08%3A_Case_Study_7_-_From_Hometown_to_Global_Village.txt |
A teenaged girl, Mary, enters the Ellendale County Public Library with a small dog and heads to the “teen books” area. She sits down at one of the tables, opens up her backpack, and takes out a textbook and piece of paper. Her dog is next to her, on the floor.
At a table next to Mary sits Ron and his mother, Alice. Ron’s mother is helping him with research for school. She notices the dog, gets up, and looks for a librarian. Upon finding one, she says, “My son is allergic to dogs and that girl brought a dog to the library. He’s not going to be able to study with the dog around. Can you do something about this?”
Susan, the librarian, knows that the library has a “no animal policy,” except for service dogs. The policy also states that the library cannot directly question patrons if the dog is a service dog. Susan looks over at Mary and does not see any visible reasons for why the dog should be there. She heads over and tells Mary that she cannot have a dog in the library.
Mary does not understand everything the librarian says because she is hearing impaired. She needs the dog to alert her to things she cannot hear. Mary responds, but Susan does not understand Mary’s speech patterns.
“I’m sorry, but you’re going to have to leave,” Susan says with finality.
Later that day, Craig, the director of the Ellendale County Public Library system, receives a phone call from Mary’s father, Joseph, who informs him about the situation. Craig’s been in his position for 3 years and with the county library for 10 years. As he listens to Joseph, he realizes that there needs to be some changes to the library’s policy and training for the librarians. He is going to bring up this issue at next week’s management meeting and have a conversation about strategies that will resolve these issues in the future.
To help Craig prepare for his management team meeting, use the cultural intelligence principles to help him analyze the situation that has occurred. You may use the following questions to guide your thinking:
1. What does Craig need to help him think through this situation?
2. What is the culture of the library? The culture of librarians at Ellendale?
3. What behaviors can you identify? What can Craig and his management team do differently that will change this behavior?
4. How can Craig and his team use self-efficacy concepts to improve their cultural intelligence?
Reflection
There are several items at play in this situation that Craig needs to understand when speaking with his staff:
CI Model in Action
• Acquire: Craig received information only from a patron, Joseph. He is disturbed at what he hears and jumps to his own conclusions about what needs to be done. It would be appropriate to hear from the librarians and others at the library about the situation. Moreover, Craig and his team need to evaluate their own cultural intelligence when working with people who have disabilities.
• Build: Cultural strategic thinking can help them assess what gaps exist in their knowledge and understanding of people who have disabilities. As a result of the assessment, they could identify organizational goals that would be beneficial to all staff, whether these goals are related to training, policy changes, behavioral changes, or customer service improvements.
• Contemplate: The mindfulness aspect of contemplation will be useful to Craig and his team. Mindfulness opens up possibilities in what seems like a closed ended situation. Using mindfulness as a tool, it is apparent here that there is a need for cultural sensitivity training for the librarians. But there is also a larger issue: the policies for patrons with disabilities need to be reviewed and reconsidered. It would be helpful for the management team to discuss how long ago the policies were created, what changes in the environment the library can expect (in terms of demographic and economic changes) that might impact their policies, and what the protocol is for addressing issues that are not included in the library’s policies.
• Do: For Craig’s team to be more adaptable, it would be helpful for them to understand their self-concepts, including the organization’s self-concept. How has the organization come to understand who they are based on their expectations and responses to their patrons? How have policies been developed as a result of these responses? Where does our organizational self-concept restrict us and create barriers to a successful change? Asking these learning questions can help them shift their thinking to a different perspective. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.09%3A_Case_Study_8_-_No_Dogs_Allowed.txt |
Abdul Hadi is one of the 3 million Muslims living in Germany today. He has had surgery and is recovering from his operations in a hospital near his home. Anna is his nurse and is increasingly frustrated with his behavior and having to accommodate his needs. His behaviors and needs are as follows:
• Because of the nature of Abdul Hadi’s surgery, it is difficult for him to take a shower or bathe himself. When preparing for prayer, he needs to cleanse himself. He needs assistance and Anna is there to provide help, but he refuses to have her help. Finding a male nurse to help bathe Abdul Hadi has been a challenge, as all of the male nurses work different shifts and are already assigned to other patients.
• As a devout Muslim, Abdul Hadi does not eat pork. Medication provided to him must not have any pork products or alcoholic substances; he is only allowed specific medications and treatments containing these products as dictated by Islamic law.
• Abdul Hadi also has special dietary needs. Because much of the cafeteria food contains pork products, gelatin, or lard, in one form or another, it is hard to find food that fits his needs while ensuring he stays healthy and strong.
• Abdul Hadi has many relatives that visit him; as a result, the patients that share his room complain about the noise and level of activity.
• As a Muslim, he prays and needs the space to do this. He needs to have a nurse help him get out of bed. Sometimes he has called Anna to help him, but because she is attending other patients, she does not come in time to assist him.
You are Anna’s supervisor. You want her to be able to work with Abdul Hadi and to provide him with the best care.
1. Using what you know about cultural intelligence, analyze the situation.
2. For each of the five behaviors and needs outlined above, find a strategy, or strategies, to resolve the issues.
3. Determine what your hospital needs to do to ensure patients are addressed with care and compassion.
CI Model in Action
• Acquire: It is important for the supervisors, including the hospital administrators, to recognize the cultural differences that exist between themselves and people of the Islamic faith. There is a specific belief and value system operating within this hospital. This system dictates how to interact with and treat patients, and as a result, policies are developed to treat and work with patients in a specific way. These ideas come into conflict when there are individuals who do not perceive care in the same way. A useful exercise for the supervisor and hospital administrators would be to identify what they currently know about the Islamic culture and what they would like to learn more about. This can include identification of organizational cultural belief systems and values related to working with patients. When they do this, it helps them to create concrete strategies for improvement.
• Build: For Anna, the supervisor can help her to assess her self-efficacy and confidence level in working with patients of different cultural and religious backgrounds. She can work with Anna to help her become a more active listener, so as to build a more trusting and respectful relationship with patients. The supervisor can also help Anna by coaching or mentoring her, which entails asking her questions, making suggestions, and exploring alternative care techniques. Doing this provides Anna and the supervisor with the opportunity to break down what is happening in the situation.
• Contemplate: It would be important for Anna to keep an open mind and suspend judgments about patient’s beliefs and religious practices. She can learn to be a better observer and listener, thus allowing her to pick up cultural nuances that she may not have otherwise noticed. Her ability to manage her emotions, gauge the patient’s emotions, and adapt as needed is really important in the care of patients. Because illnesses can be a large source of physical and emotional stress, Anna’s assistance in helping patients to manage their emotional responses could only benefit her.
• Do: The supervisor can help Anna to learn to identify behaviors that are inappropriate and are a setback to the patient’s health and well-being. Learning to name the emotions and identify the thought patterns that occur while working with Abdul Hadi can help Anna to release negative emotions and feelings she has toward the patient. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.10%3A_Case_Study_9_-_Faith_and_Health.txt |
Pattie works as a corporate lawyer at Hannigan, Fisher, and Schultz, a firm known for its work in intellectual property and securities law. Prior to her job, she served as a corporate attorney for a large Fortune 500 company located in San Jose, California. She is the mother of two young boys, 7 and 4 years old. Her husband works a full-time job as a financial manager for a prestigious financial services company. Even though Pattie and her husband lead busy professional lives, they always make sure that their two children come first. Jack, the younger of the two, was diagnosed with severe epilepsy 2 years ago, and the family wants to ensure that Jack receives the best care and attention.
In the past 7 years that Pattie has been with the firm, she has done everything she can to be promoted to partner. She has developed a large network of professional relationships. She has worked hard to demonstrate her leadership and management potential to her supervisors, and has led multi-million-dollar team projects. She has brought in new business and meets all her billable hours. She does all this while attending to her family’s special needs.
This year, only two associates were promoted to partner; both were men, both with the firm for less than 5 years. When she learned of this, she spoke with Robert, a senior partner and close colleague of hers: “Robert, what’s going on here? I’ve been here for six years, done everything according to the book, and yet I get passed up? I thought you said you were going to go to bat for me this year?”
“I did.” Robert hesitates and says, “You know, it’s hard to convince a bunch of old guys that you’re committed to your job.”
“Commitment? What are you talking about? You, of all people, know how hard I work,” Pattie replies. “Wait a minute. Is this about me working from home to take care of Jack this year?”
“Listen, it’s a tough world out here. They just want to know you’re going to be there for them; you know, keep bringing in the money. That’s how it is around here. It’s a ‘do as we say or there’s the door’ attitude around here. I’m sorry Pattie, but I’ll do what I can to support you—just hang in there.”
Using your knowledge about cultural intelligence principles, analyze what you believe is happening in this firm, and then identify three suggestions you have for the leadership of this organization.
Reflection
Pattie works in a male-dominated law firm that seems to be entrenched in beliefs and values about women’s work and the work of attorneys. Although she has an ally in Robert, she still feels alone and discriminated against. In a situation such as this, Robert and Pattie would need to bring to the attention of their managers the subtle and insidious ways in which gender inequality occurs in the firm. This is a huge challenge, especially when partners in the firm do not see the problem or they view the problem as something different than gender equality.
Here is a situation in which Pattie must evaluate her beliefs and values and whether they align with the culture of the law firm. She needs to determine whether it is worth it for her to stay at the law firm or to bring more attention to the issue. Since she has Robert as an ally, and since he is a senior partner in the firm, he can be the support and advocate she needs to bring attention to the issue. Additionally, because of his position, he has the power to bring awareness of gender inequality issues to his managers and colleagues.
CI Model in Action
• Acquire: In a situation like this, organizational leaders need to shift the way they think about women’s work as attorneys. There are specific beliefs and values involved, unexpressed but felt by Pattie and most likely other women in the firm. The firm of Hannigan, Fisher, and Schultz must recognize the cultural norms that sustain the behaviors. Because Robert is Pattie’s ally and a senior partner, he can advocate for her, but he needs to know what cultural dynamics are occurring in the organization to be able to articulate and communicate the issues to his supervisors. As he makes his case, he can ask himself questions like “What’s the big picture?” or “What’s possible here?”
• Build: Robert can continue to support Pattie by acting as a coach or mentor. But, in his role as coach or mentor, he must pay attention to the cultural elements such as her gender, age, legal experience, and seniority in the firm, even the organization’s culture. These cultural elements will likely impact the types of suggestions he has for her and the kind of support he can give her.
• Contemplate: In this situation, because the organization is entrenched in very specific belief and value systems, Pattie may never get to be a partner. She will need to consider what keeps her motivated to be in the job and why she would want to work for the firm. She cannot allow the situation to lower her self-efficacy; rather, she must make the most of it given her situation. As she learns more about her values and goals (self-concept), she may find that she no longer wants to work in the firm.
• Do: Because Pattie cannot change the minds of her employers, the best she can do is to understand who she is in the situation and how she wants to manage it. She can make the situation worse by holding a negative attitude or she can choose to manage her emotions effectively until she decides what to do. Opening herself to other possibilities might seem challenging given her family situation; but as she adapts to the changes in her life, she will eventually transition into a better place. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/07%3A_Cultural_Intelligence_in_Action/7.11%3A_Case_Study_10_-_An_Old_Boys_Club.txt |
One day an elephant saw a hummingbird lying flat on its back on the ground; its feet in the air.
“What are you doing,” asked the elephant.
The hummingbird replied, “I heard that the sky might fall today. If that happens, I am ready to do my part to hold it up.”
The elephant laughed and mocked the bird. “You think those feet can hold up the sky?”
“Not alone,” said the bird. “But we must each do what we can, and this is what I can do.”
Adapted from R. MacDonald, Three minute tales
How can we ensure that our leadership matters at a very deep level? What can we do to cultivate awareness for cultural intelligence in all individuals within our organizations? As this Chinese fable tells, we have a responsibility to one another.
This book began with the idea that there are important factors changing the way we do our work, the way we connect with one another, and how we perceive one another. Technological, political, and environmental changes are fueling a global economy that is quickly flattening; our interdependence with one another goes beyond our relationships in the workplace. All of these factors create new world experiences.
When asked to describe the “person of tomorrow,” Carl Rogers,Rogers (1980), p. 350. one of the founders of the field of humanistic psychology, said that in the new world, people will have a desire for creating wholeness in life, thought, and feelings. This “person of tomorrow” will have a need to find and create new experiences that bring a deeper understanding of humanity to work. Similarly, Frances Hasselbein, the former CEO of Girl Scouts, said that people in our societies are looking to find themselves. There is a thirst for personal and inner knowledge and a thirst to understand how this information will uncover a more profound awareness for how we relate to one another.
There are four areas in which cultural intelligence will significantly improve our understanding of culture and intercultural work. These areas are reframing, adaptive work, systems thinking, and consciousness.
8.02: Reframing
Leaders must be able to reframe their thinking and practice of culture. Cultural intelligence is a tool that helps move leaders from a place of single perspective to one that has multiple filters for sorting through and navigating the cultural intelligence labyrinth. The idea and the practice of shifting your perspective (reframing)Bolman and Deal (2008). allows leaders to move from mindlessness to mindfulness. It enables leaders to identify old thought patterns that lead to destructive and negative behaviors, which, in turn, impact and influence one’s leadership.
One of the areas that cultural intelligence can help us reframe is the changing demographics and environmental landscape we experience as a society. As we see globalization’s effects in the world, we must reframe how to think about and include different stakeholders in our work. Who we involve matters. Who we ask to be part of the conversation matters. And, most importantly, how we engage them is critical. Cultural intelligence, when used, can help to move people from the margins of work to the center, thus engaging them and creating systems of inclusion rather than representation.
I found reframing to be beneficial to leaders when developing long-lasting and meaningful intercultural relationships. For this to happen, it is vital for leaders and organizations to change their thinking about and practices concerning relationships. Leaders can create a shift in cultivating authentic relationships with different cultural groups or individuals when the questions asked are shifted from “how can this relationship help me to reach my organizational (personal) goals” to “what can I (we) learn from this relationship, and how can the learning move us toward our vision?”
I suggested this question to a woman who manages volunteers in a nonprofit. In our brief conversation, she realized that asking the question in this way helped her to see culture and diversity as a process rather than an outcome. She realized that it was important to build relationships for diversity work, but in doing so the relationships built can have a larger impact than the diversity efforts themselves. By asking questions such as “what forms of relationships need to exist in this organization,” “what do relationships mean to this organization,” and “how do people in this organization work together” enables the organization to become a learning organization based around diversity and culture.
Asking these questions enables people to be more authentic and understanding of how relationships are created. This is a critical element in cultural intelligence work as it helps leaders to tap into the power that relationships have in building trust and unity. When we engage in this type of work, we reframe how we think about culture as it relates to power, decision making, authority, and leadership. We reframe who our values speak to and who they exclude, and we gain clarity about where our responsibility within our societies exists. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/08%3A_The_Future_of_Cultural_Intelligence/8.01%3A_Introduction.txt |
It is clear that the practice of cultural intelligence forces leaders to be more adaptive to their surroundings. Adaptive work requires a change in values, beliefs, or behavior.Heifetz (1994), p. 22. Furthermore, it requires leaders to lead through conflicting values held by different groups and to eliminate the gap between the values people have and the realities of their lives. Ronalid Heifetz wrote, “Adapting to human challenges requires that we go beyond the requirements of simply surviving. We perceive problems whenever circumstances do not conform to the way we think things ought to be. Thus, adaptive work involves not only the assessment of reality but also the clarification of values.”Heifetz (1994), p. 31.
Leaders are defined by their values, their beliefs, and their character. To be culturally intelligent means that you must constantly review, revise, and reflect upon your personal value systems and how these systems impact your cultural interactions. Leaders must understand and articulate what values drive their behaviors and attitudes. This means that leaders must question and challenge, that they explore the deeper stories that give life to their belief systems, and that they are courageous enough to give themselves a “reality check” for any dissonance surfacing between their beliefs and actions.
Too often, I see organizations develop assessments and tools to measure the effectiveness of “the organization as a system,” and forget about the most important system, the “personal value system” that drives most of organizational processes and thinking. By doing this, organizational leaders expect the organization to adapt but do not have the support of its workers. We need to be reminded that organizational systems come about because there are people within the organization who are driven by their personal values and beliefs. Organizations can adapt if the people within them are given the opportunity and resources to adapt.
8.04: Interdependency
Martin Luther King, Jr., said that “Whatever affects one directly, affects all indirectly.” Relationships and interdependence are at the core of our survival. Peter Senge wrote that leaders of the future must have the skill set to “see patterns of interdependency.”Senge (1990), p. 39. We live in an interdependent world; our actions and choices know no boundaries. Senge suggests that we must see the connections and relationships between, among, and within systems—cultural, political, legal, social, economic, familial, and so on. We need to be able to live effectively with one another, and if we can “see systemic patterns and understand the forces driving a system,” we can “start to see where the system is headed if nothing changes.”Senge (1990), p. 39.
To begin to see interdependence, culturally intelligent leaders need to be clear about their purpose in working with cultural groups, people, and processes. Purpose, in culturally intelligent leadership, is to understand oneself in relationship to what is being sought. In other words, understanding and exploring your motivations, your passion, and your personal journey must serve as a foundation for reaching the desired vision to create cultural understanding and awareness. You must personally explore and identify what it would mean to the organization, and most importantly to its people, if diversity and culture of thoughts, ideas, people, systems did not exist.
Simply asking yourself and others, “if we did not do this work, what would be lost,” can help people to understand the systemic nature of culture. I once worked with a manager who asked this question of himself, and then his staff. The result was a deep and authentic dialogue about the responsibility that each person brings to the process. They understood that culture and diversity was not something to control or “manage,” rather it was a human element that needed to be nurtured and cared for by everyone. The intercultural work to be explored involved everyone no matter what level of cultural consciousness they came into the organization with. In the end, people in the organization gained an understanding for the different notions of diversity, a more clear purpose and passion for intercultural interactions, and enthusiastic support for creating a culturally inclusive environment. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/08%3A_The_Future_of_Cultural_Intelligence/8.03%3A_Adaptive_Work.txt |
As we progress in our understanding of culture we learn through our cognition what it takes to be a leader in an intercultural world. What is required, as evident in the idea of cultural intelligence, is a more holistic, paradoxical picture of leadership. The picture is one that must engage people’s whole self, including the emotional, physical, mental, social, and spiritual domains.
This picture of leadership also forces us to recognize that the opposites we see, for example individualism and collectivism, are not in conflict; rather, they complement each other, enabling us to look at our individual and group strengths and our weaknesses in its totality. Opposites are not to demonstrate a “better than the other” dichotomy; instead, opposites create harmony, helping us to discover where we have been out of balance. Culturally intelligent leaders know they must balance the paradoxes of life: judge and learn, individual and group, strength and weakness, old and new, mindfulness and mindlessness, possible and impossible, and so on.
We are, as Carl Rogers noted, in a time where consciousness is critical to our self-development and, thus, the development of others. Through consciousness-raising activities such as cultural intelligence, we have the opportunity to let go of our limiting thoughts and behaviors. This consciousness creation is what Mary Parker Follet noted as both the social and political force of the future. It is through this creation, a collective conscious, that creative forces will emerge and work through the chaos and complexity of our times.
8.06: A Return to the Cultural Labyrinth
Joseph CampbellCampbell (1988). said that by going down into the abyss, we remember the treasures of life. In cultural intelligence, leaders must be able to raise their levels of collective cultural consciousness by seeking out the challenges, or our “abyss”. It is often difficult to disclose one’s weaknesses, one’s fears, and one’s vulnerabilities concerning cultural diversity: The abyss is not really a comfortable place to be, but it does serve as an opportunity to explore one’s self-concept. Cultural intelligence provides leaders with a chance to expand their capacities to become better cross-cultural leaders.
In the end, when you reach your destination, you will be changed. In our cultural intelligence journey, we all return to our core, our home, our center. We come back not as the same person, because the world we left that was familiar to us is now unfamiliar. Campbell said that when we return to our true selves—our authentic selves—we need to be willing to rid ourselves of the life we have planned in order to enjoy the life that waits. Once you begin the work of cultural intelligence, you can no longer be the same person; you cannot go back to who you were and pick up the pieces as you left them. Your leadership story is different, and how you engage with people of different cultural backgrounds will be different.
If you truly do work that is culturally intelligent, work that is meaningful and intentional, then you will come to realize that differences in cultures promote a diversity of thinking, innovative practices, and ideas that take you out of mindlessness. Cultural intelligence keeps you alert and attentive to challenges in order to help you reach your highest potential. In business, culture’s impact is to constantly test an organization’s ability to be adaptable and flexible—to be the best by letting go of old assumptions and biases. It has always been the role of culture to help us let go of what we think we know and open our eyes to the responsibility we all have, as leaders, in shaping a better society. | textbooks/biz/Management/Leading_with_Cultural_Intelligence/08%3A_The_Future_of_Cultural_Intelligence/8.05%3A_Consciousness.txt |
Learning Objectives
1. Describe the concept of stakeholders and identify the stakeholder groups relevant to an organization
2. Discuss and be able to apply the macro-business environment model to an industry or emerging technology
3. Explain other key terms related to this chapter including: entrepreneur; profit; revenue
Introduction
Today is an interesting time to study business. Advances in technology are bringing rapid changes in the ways we produce and deliver goods and services. The Internet and other improvements in communication (such as smartphones, video conferencing, and social networking) now affect the way we do business. Companies are expanding international operations, and the workforce is more diverse than ever. Corporations are being held responsible for the behavior of their executives, and more people share the opinion that companies should be good corporate citizens. Because of the role they played in the worst financial crisis since the Great Depression, businesses today face increasing scrutiny and negative public sentiment.[1]
Economic turmoil that began in the housing and mortgage industries as a result of troubled subprime mortgages quickly spread to the rest of the economy. In 2008, credit markets froze up and banks stopped making loans. Lawmakers tried to get money flowing again by passing a \$700 billion Wall Street bailout, now-cautious banks became reluctant to extend credit. Without money or credit, consumer confidence in the economy dropped and consumers cut back on spending. Unemployment rose as troubled companies shed the most jobs in five years, and 760,000 Americans marched to the unemployment lines.[2] The stock market reacted to the financial crisis and its stock prices dropped by 44% while millions of Americans watched in shock as their savings and retirement accounts took a nose dive. In fall 2008, even Apple, a company that had enjoyed strong sales growth over the past five years, began to cut production of its popular iPhone. Without jobs or cash, consumers would no longer flock to Apple’s fancy retail stores or buy a prized iPhone.[3] Since then, things have turned around for Apple, which continues to report blockbuster sales and profits. But not all companies or individuals are doing so well. The economy is still struggling, unemployment is high (particularly for those ages 16 to 24), and home prices have not fully rebounded from the crisis.
As you go through the course with the aid of this text, you’ll explore the exciting world of business. We’ll introduce you to the various activities in which business people engage— accounting, finance, information technology, management, marketing, and operations. We’ll help you understand the roles that these activities play in an organization, and we’ll show you how they work together. We hope that by exposing you to the things that business people do, we’ll help you decide whether a business is right for you and, if so, what areas of business you’d like to study further.
Getting Down to Business
A business is any activity that provides goods or services to consumers for the purpose of making a profit. Be careful not to confuse the terms revenue and profit. Revenue represents the funds an enterprise receives in exchange for its goods or services. Profit is what’s left (hopefully) after all the bills are paid. When Steve Jobs and Steve Wozniak launched the Apple I, they created Apple Computer in Jobs’ family garage in the hope of making a profit. Before we go on, let’s make a couple of important distinctions concerning the terms in our definitions.
First, whereas Apple produces and sells goods(Mac, iPhone, iPod, iPad, Apple Watch), many businesses provide services. Your bank is a service company, as is your Internet provider. Hotels, airlines, law firms, movie theaters, and hospitals are also service companies. Many companies provide both goods and services. For example, your local car dealership sells goods (cars) and also provides services (automobile repairs).
Second, some organizations are not set up to make profits. Many are established to provide social or educational services. Such not-for profit (or nonprofit), organizations include the United Way of America, Habitat for Humanity, the Boys and Girls Clubs, the Sierra Club, the American Red Cross, and many colleges and universities. Most of these organizations, however, function in much the same way as a business. They establish goals and work to meet them in an effective, efficient manner. Thus, most of the business principles introduced in this text also apply to nonprofits.
Business Participants and Activities
Let’s begin our discussion of business by identifying the main participants of business and the functions that most businesses perform. Then we’ll finish this section by discussing the external factors that influence a business’ activities.
Participants
Every business must have one or more owners whose primary role is to invest money in the business. When a business is being started, it’s generally the owners who polish the business idea and bring together the resources (money and people) needed to turn the idea into a business. The owners also hire employees to work for the company and help it reach its goals. Owners and employees depend on a third group of participants— customers. Ultimately, the goal of any business is to satisfy the needs of its customers in order to generate a profit for the owners.
Stakeholders
Consider your favorite restaurant. It may be an outlet or franchise of a national chain (more on franchises in a later chapter) or a local “mom and pop” without affiliation to a larger entity. Whether national or local, every business has stakeholders– those with a legitimate interest in the success or failure of the business and the policies it adopts. Stakeholders include customers, vendors, employees, landlords, bankers, and others (see Figure 1.2). All have a keen interest in how the business operates, in most cases for obvious reasons. If the business fails, employees will need new jobs, vendors will need new customers, and banks may have to write off loans they made to the business. Stakeholders do not always see things the same way – their interests sometimes conflict with each other. For example, lenders are more likely to appreciate high profit margins that ensure the loans they made will be repaid, while customers would probably appreciate the lowest possible prices. Pleasing stakeholders can be a real balancing act for any company.
Functional Areas of Business
The activities needed to operate a business can be divided into a number of functional areas. Examples include: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas.
Management
Managers are responsible for the work performance of other people. Management involves planning for, organizing, leading, and controlling a company’s resources so that it can achieve its goals. Managers plan by setting goals and developing strategies for achieving them. They organize activities and resources to ensure that company goals are met and staff the organization with qualified employees and managers lead them to accomplish organizational goals. Finally, managers design controls for assessing the success of plans and decisions and take corrective action when needed.
Operations
All companies must convert resources (labor, materials, money, information, and so forth) into goods or services. Some companies, such as Apple, convert resources into tangible products—Macs, iPhones, etc. Others, such as hospitals, convert resources into intangible products — e.g., health care. The person who designs and oversees the transformation of resources into goods or services is called an operations manager. This individual is also responsible for ensuring that products are of high quality.
Marketing
Marketing consists of everything that a company does to identify customers’ needs (i.e. market research) and design products to meet those needs. Marketers develop the benefits and features of products, including price and quality. They also decide on the best method of delivering products and the best means of promoting them to attract and keep customers. They manage relationships with customers and make them aware of the organization’s desire and ability to satisfy their needs.
Accounting
Managers need accurate, relevant and timely financial information, which is provided by accountants. Accountants measure, summarize, and communicate financial and managerial information and advise other managers on financial matters. There are two fields of accounting. Financial accountants prepare financial statements to help users, both inside and outside the organization, assess the financial strength of the company. Managerial accountants prepare information, such as reports on the cost of materials used in the production process, for internal use only.
Finance
Finance involves planning for, obtaining, and managing a company’s funds. Financial managers address such questions as the following: How much money does the company need? How and where will it get the necessary money? How and when will it pay the money back? What investments should be made in plant and equipment? How much should be spent on research and development? Good financial management is particularly important when a company is first formed, because new business owners usually need to borrow money to get started.
External Forces that Influence Business Activities
Apple and other businesses don’t operate in a vacuum: they’re influenced by a number of external factors. These include the economy, government, consumer trends, technological developments, public pressure to act as good corporate citizens, and other factors. Collectively, these forces constitute what is known as the “macro environment” – essentially the big picture world outside over which the business exerts very little if any control. Figure 1.3 “Business and Its Environment” sums up the relationship between a business and the external forces that influence its activities. One industry that’s clearly affected by all these factors is the fast-food industry. Companies such as Taco Bell, McDonald’s, Cook-Out and others all compete in this industry. A strong economy means people have more money to eat out. Food standards are monitored by a government agency, the Food and Drug Administration. Preferences for certain types of foods are influenced by consumer trends (fast food companies are being pressured to make their menus healthier). Finally, a number of decisions made by the industry result from its desire to be a good corporate citizen. For example, several fast-food chains have responded to environmental concerns by eliminating Styrofoam containers.[4]
Of course, all industries are impacted by external factors, not just the food industry. As people have become more conscious of the environment, they have begun to choose new technologies, like all-electric cars to replace those that burn fossil fuels. Both established companies, like Nissan with its Nissan Leaf, and brand new companies like Tesla have entered the market for all-electric vehicles. While the market is still small, it is expected to grow at a compound annual growth rate of 19.2% between 2013 and 2019.[5]
Key Takeaways
1. The main participants in a business are its owners, employees, and customers.
2. Every business must consider its stakeholders, and their sometimes conflicting interests, when making decisions.
3. The activities needed to run a business can be divided into functional areas. The business functions correspond fairly closely to many majors found within a typical college of business.
4. Businesses are influenced by such external factors as the economy, government, and other forces external to the business.
What Makes Shopify Successful? [6]
1. The system is scalable: An infinitely scalable SaaS platform. Even if you don’t totally understand what that means, you can rest easy knowing it means your site will never crash. A fast and easy experience awaits every customer, any time.
2. The system is secure: Customers need to feel that their personal information, including credit cards, is safe when they shop online. Shopify is certified Level 1 PCI DSS compliant, meaning Shopify has been deemed compliant in six different categories set out by the Payment Card Industry Data Security Standard.
3. An API makes integrations fast and easy: Shopify is built for seamless integrations, which makes everyone happier. Their API lets you connect to your existing IT platform and the ERP, web app, CRM, accounting systems, a preferred CMS and other third party software.
4. Healthy 3rd Party developer community lowers cost of adding plugins for specific features: For the last six years Shopify Plus has been augmented by pre-approved apps that add features or customize things on the backend. The ecosystem that produces these add-ons and plugins is is regulated and overseen by Shopify, which helps ensure quality. For even the most complex logistics, there’s likely an affordable solution already available.
5. Marketing Automation Capabilities: Shopify Plus offers built-in automation features such as Abandoned Checkout Recovery in the Professional or Unlimited plan. There are several apps available for the basic plan to add this feature.
6. Advanced Reporting for SEO: Shopify knows shoppers need to find you. Their advanced eCommerce CMS and shopping cart feature customizable H1, title and meta tags for SEO best practice, helping bring in traffic and getting you noticed by Google, Bing and Yahoo. Plus, new products and site changes show up fast on search engines through automatic sitemaps.xml file generation.
7. 24/7 support: eCommerce means your store is open all the time. Shopify gets it and offers a support team available all day, every day. No filling out an online form and waiting for a reply for days. Email, live chat and phone are all available. When you’re in business, so is Shopify.
8. eCommerce University education series great for beginners and the experienced alike: Shopify wants your business to thrive and offers a huge range of free tools and resources to build your store and your success. Free guides, a forum, online marketing advice, and in-depth case studies help you build, launch and grow your own online business.
9. Easy to use: All those options and features are great. But Shopify Plus is better than great because it’s easy to use. User friendly to the max, Shopify has set itself apart as the ecommerce option focused on ease of use, allowing companies to focus on customer experience and marketing instead of building out, maintaining and working in expensive systems.
10. Shopify Plus API: For the enterprise customers that have Magento, SAP, SAGE, NetSuite or other ERP solutions. The ability to easily port over existing customers, make integrations easily at low cost, and transact at lower cost is very appealing. Shopify Plus is really helping enterprise take advantage of many tools thought to be for small business. Shopify Plus vs Magento Enterprise, we would pick Shopify Plus any day.
1. Jon Hilsenrath, Serena Ng, and Damian Paletta (2008). “Worst Crisis Since ’30s, With No End Yet in Sight,” Wall Street Journal, Markets, September 18, 2008. Retrieved from: http://www.wsj.com/articles/SB122169431617549947
2. Steve Hargreaves (2008). “How the Economy Stole the Election,” CNN.com. Retrieved from: http://money.cnn.com/galleries/2008/news/0810/gallery.economy_election/index.html
3. Dan Gallagher (2008). “Analyst says Apple is cutting back production as economy weakens.” MarketWatch. Retrieved from: http://www.marketwatch.com/story/apple-cutting-back-iphoneproduction-analyst-says?amp%3Bdist=msr_1
4. David Baron (2003). “Facing-Off in Public.” Stanford Business. August 2003, pp. 20-24. Retrieved from: https://www.gsb.stanford.edu/sites/gsb/files/2003August.pdf
5. Transparency Market Research (2014). “Electric Vehicles Market (on-road) (hybrid, plug-in, and battery) - Global Industry Analysis, Size, Share, Growth, Trends and Forecast, 2013 – 2019.” Retrieved from: http://www.transparencymarketresearch.com/electric-vehicles-market.html
6. Source: Parmar (2016). https://www.quora.com/What-makes-Shopify-successful. | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/01%3A_Foundations_of_Business/1.01%3A_Chapter_1-_Foundations_of_Business.txt |
Learning Objectives
• Be able to explain what is meant by business success.
• Be able to describe the different components of business failure.
• Understand that statistics on business failure can be confusing and contradictory.
• Understand that small business failure can be traced to managerial inadequacy, financial issues, and the external environment.
• Understand that small business owners need to be able to formally plan and understand the accounting and finance needs of their firms
What Is a Successful Small Business?
Ask the average person what the purpose of a business is or how he or she would define a successful business, and the most likely response would be “one that makes a profit.” A more sophisticated reply might extend that to “one that makes an acceptable profit now and in the future.” Ask anyone in the finance department of a publicly held firm, and his or her answer would be “one that maximizes shareholder wealth.” The management guru Peter Drucker said that for businesses to succeed, they needed to create customers, while W. E. Deming, the quality guru, advocated that business success required “delighting” customers. No one can argue, specifically, with any of these definitions of small business success, but they miss an important element of the definition of success for the small business owner: to be free and independent.
Many people have studied whether there is any significant difference between the small business owner and the entrepreneur. Some entrepreneurs place more emphasis on growth in their definition of success.[1] However, it is clear that entrepreneurs and small business owners define much of their personal and their firm’s success in the context of providing them with independence. For many small business owners, being in charge of their own life is the prime motivator: a “fervently guarded sense of independence,” and money is seen as a beneficial byproduct.[2][3][4] Oftentimes, financial performance is seen as an important measure of success. However, small businesses are reluctant to report their financial information, so this will always be an imperfect and incomplete measure of success. [5] Three types of small business operators can be identified based on what they see as constituting success:
1. An artisan whose intrinsic satisfaction comes from performing the business activity
2. The entrepreneur who seeks growth
3. The owner who seeks independence[6]
When discussing failure rates in small business, there is only one appropriate word: confusion. There are wildly different values, from 90 percent to 1 percent, with a wide range of values in between.[7] Obviously, there is a problem with these results, or some factor is missing. One factor that would explain this discrepancy is the different definitions of the term failure. A second factor is that of timeline. When will a firm fail after it starts operation?
The term failure can have several meanings.[8] Small-business failure is often measured by the cessation of a firm’s operation, but this can be brought about by several things:
• An owner can die or simply choose to discontinue operations.
• The owner may recognize that the business is not generating sufficient return to warrant the effort that is being put into it. This is sometimes referred to as the failure of opportunity cost.
• A firm that is losing money may be terminated to avoid losses to its creditors.
• There can be losses to creditors that bring about cessations of the firm’s operations
• The firm can experience bankruptcy. Bankruptcy is probably what most people think of when they hear the term business failure. However, the evidence indicates that bankruptcies constitute only a minor reason for failure.
Failure can therefore be thought of in terms of a cascading series of outcomes (see Figure 2.1 “Types of Business Failures”). There are even times when small business owners involved in a closure consider the firm successful at its closing.[9] Then there is the complication of considering the industry of the small business when examining failure and bankruptcy. The rates of failure can vary considerably across different industries; in the fourth quarter of 2009, the failure rates for service firms were half that of transportation firms.[10]
The second issue associated with small business failure is a consideration of the time horizon. Again, there are wildly different viewpoints. The Dan River Small Business Development Center presented data that indicated that 95 percent of small businesses fail within five years.[11] Dun and Bradstreet reported that companies with fewer than twenty employees have only a 37 percent chance of surviving four years, but only 10 percent will go bankrupt.[12] The US Bureau of Labor Statistics indicated that 66 percent of new establishments survive for two years, and that number drops to 44 percent two years later.[13] It appears that the longer you survive, the higher the probability of your continued existence. This makes sense, but it is no guarantee. Any business can fail after many years of success.
Why Do Small Businesses Fail?
There is no more puzzling or better studied issue in the field of small business than what causes them to fail. Given the critical role of small businesses in the US economy, the economic consequences of failure can be significant. Yet there is no definitive answer to the question.
Three broad categories of causes of failure have been identified: managerial inadequacy, financial inadequacy, and external factors. The first cause,managerial inadequacy, is the most frequently mentioned reason for firm failure.[14] Unfortunately, it is an all-inclusive explanation, much like explaining that all plane crashes are due to pilot failure. Over thirty years ago, it was observed that “while everyone agrees that bad management is the prime cause of failure, no one agrees what ‘bad management’ means nor how it can be recognized except that the company has collapsed—then everyone agrees that how badly managed it was.”[15] This observation remains true today.
The second most common explanation cites financial inadequacy, or a lack of financial strength in a firm. A third set of explanations center on environmental or external factors, such as a significant decline in the economy. Because it is important that small firms succeed, not fail, each factor will be discussed in detail. However, these factors are not independent elements distinct from each other. A declining economy will depress a firm’s sales, which negatively affects a firm’s cash flow. An owner who lacks the knowledge and experience to manage this cash flow problem will see his or her firm fail.
Managerial inadequacy is generally perceived as the major cause of small business failure. Unfortunately, this term encompasses a very broad set of issues. It has been estimated that two thirds of small business failures are due to the incompetence of the owner-manager.[16] The identified problems cover behavioral issues, a lack of business skills, a lack of specific technical skills, and marketing myopia. Specifying every limitation of these owners would be prohibitive. However, some limitations are mentioned with remarkable consistency. Having poor communication skills, with employees and/or customers, appears to be a marker for failure.[17] The inability to listen to criticism or divergent views is a marker for failure, as is the inability to be flexible in one’s thinking.[18]
Ask many small business owners where their strategic plans exist, and they may point to their foreheads. The failure to conduct formal planning may be the most frequently mentioned item with respect to small business failure. Given the relative lack of resources, it is not surprising that small firms tend to opt for intuitive approaches to planning.[19][20] Formal approaches to planning are seen as a waste of time,[21] or they are seen as too theoretical.[22] The end result is that many small business owners fail to conduct formal strategic planning in a meaningful way.[23][24] In fact, many fail to conduct any planning;[25][26] others may fail to conduct operational planning, such as marketing strategies.[27] The evidence appears to clearly indicate that a small firm that wishes to be successful needs to not only develop an initial strategic plan but also conduct an ongoing process of strategic renewal through planning.
Many managers do not have the ability to correctly select staff or manage them.[28] Other managerial failings appear to be in limitations in the functional area of marketing. Failing firms tend to ignore the changing demands of their customers, something that can have devastating effects.[29] The failure to understand what customers value and being able to adapt to changing customer needs often leads to business failure.[30]
The second major cause of small business failure is finance. Financial problems fall into three categories: start-up, cash flow, and financial management. When a firm begins operation (startup), it will require capital. Unfortunately, many small business owners initially underestimate the amount of capital that should be available for operations.[31] This may explain why most small firms that fail do so within the first few years of their creation. The failure to start with sufficient capital can be attributed to the inability of the owner to acquire the needed capital. It can also be due to the owner’s failure to sufficiently plan for his or her capital needs. Here we see the possible interactions among the major causes of firm failure. Cash-flow management has been identified as a prime cause for failure.[32][33] Good cash-flow management is essential for the survival of any firm, but small firms, in particular, must pay close attention to this process.
Small businesses must develop and maintain effective financial controls, such as credit controls.[34] For very small businesses, this translates into having an owner who has at least a fundamental familiarity with accounting and finance.[35] In addition, the small firm will need either an in-house or an outsourced accountant.[36] Unfortunately, many owners fail to fully use their accountants’ advice to manage their businesses.[37]
The last major factor identified with the failure of small businesses is the external environment. There is a potentially infinite list of causes, but the economic environment tends to be most prominent. Here again, however, confusing appears to describe the list. Some argue that economic conditions contribute to between 30 percent and 50 percent of small business failures, in direct contradiction to the belief that managerial incompetence is the major cause.[38] Two economic measures appear to affect failure rates: interest rates, which appear to be tied to bankruptcies, and the unemployment rate, which appears to be tied to discontinuance.[39] The potential impact of these external economic variables might be that small business owners need to be either planners to cover potential contingencies or lucky.
Even given the confusing and sometimes conflicting results with respect to failure in small businesses, some common themes can be identified. The reasons for failure fall into three broad categories: managerial inadequacy, finance, and environmental. They, in turn, have some consistently mentioned factors (see Table 2.1 “Reasons for Small Business Failure”). These factors should be viewed as warning signs—danger areas that need to be avoided if you wish to survive. Although small business owners cannot directly affect environmental conditions, they can recognize the potential problems that they might bring. This text will provide guidance on how the small business owner can minimize these threats through proactive leadership.
Table 2.1 Reasons for Small Business Failure
Managerial Inadequacy Financial Inadequacy External Factors
• Failure in planning (initial start-up plan and subsequent plans)
• Inexperience with managing business operation
• Ineffective staffing
• Poor communication skills
• Failure to seek or respond to criticism
• Failure to learn from past failures
• Ignoring customers’ needs
• Ignoring competition
• Failure to diversify customer base
• Failure to innovate
• Ineffective marketing strategies
• Cash-flow problems
• Insufficient initial capitalization
• Inadequate financial records
• Not using accountants’ insights
• Inadequate capital acquisition strategies
• Failure to deal with financial issues brought about by growth
• Downturn in economy
• Rising unemployment
• Rising interest rates
• Product or service no longer desired by customers
• Unmatchable foreign competition
• Fraud
• Disaster
Ultimately, business failure will be a company-specific combination of factors. Monitor101, a company that developed an Internet information monitoring product for institutional investors in 2005, failed badly. One of the cofounders identified the following seven mistakes that were made, most of which can be linked to managerial inadequacy:[40]
1. The lack of a single “the buck stops here” leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much public relations, too early
4. Too much money
5. Not close enough to the customer
6. Slowness to adapt to market reality
7. Disagreement on strategy within the company and with the board
“Entrepreneurs Turn Business Failure into Success” Bloomberg Businessweek’s 2008 cover story highlights owners who turn business failure into success. [41]
Key Takeaways
• There is no universal definition for small business success. However, many small business owners see success as their own independence.
• The failure rates for small businesses are wide ranging. There is no consensus.
• Three broad categories of factors are thought to contribute to small business failure: managerial inadequacy, financial inadequacy, and external forces, most notably the economic environment.
Exercises
1. Starting a business can be a daunting task. It can be made even more daunting if the type of business you choose is particularly risky. Go to: www.forbes.com/2007/01/18/fairisaac-nordstromverizon-ent-fincx_mf_0118risky_slide.html?thisSpeed=undefined; where the ten riskiest businesses are identified. Select any two of these businesses and address why you think they are risky
2. Amy Knaup is the author of a 2005 study “Survival and Longevity in the Business Employment Dynamics Data” ( seewww.bls.gov/opub/mlr/2005/05/ressum.pdf ). The article points to different survival rates for ten different industries. Discuss why there are significant differences in the survival rates among these industries.
1. William Dunkelberg and A. C. Cooper. “Entrepreneurial Typologies: An Empirical Study,” Frontiers of Entrepreneurial Research, ed. K. H. Vesper (Wellesley, MA: Babson College, Centre for Entrepreneurial Studies, 1982), 1–15.
2. “Report on the Commission or Enquiry on Small Firms,” Bolton Report, vol. 339 (London: HMSO, February 1973), 156–73.
3. Paul Burns and Christopher Dewhurst, Small Business and Entrepreneurship, 2nd ed. (Basingstoke, UK: Macmillan, 1996), 17.
4. Graham Beaver, Business, Entrepreneurship and Enterprise Development(Englewood Cliffs, NJ: Prentice Hall, 2002), 33.
5. Terry L. Besser, “Community Involvement and the Perception of Success Among Small Business Operators in Small Towns,” Journal of Small Business Management 37, no 4 (1999): 16.
6. M. K. J. Stanworth and J. Curran, “Growth and the Small Firm: An Alternative View,” Journal of Management Studies 13, no. 2 (1976): 95–111.
7. Roger Dickinson, “Business Failure Rate,” American Journal of Small Business 6, no. 2 (1981): 17–25.
8. A. B. Cochran, “Small Business Failure Rates: A Review of the Literature,”Journal of Small Business Management 19, no. 4, (1981): 50–59.
9. Don Bradley and Chris Cowdery, “Small Business: Causes of Bankruptcy,” July 26, 2004, accessed October 7, 2011, http://www.sbaer.uca.edu/research/asbe/2004_fall/16.pdf.
10. “Equifax Study Shows the Ups and Downs of Commercial Credit Trends,”Equifax, 2010, accessed October 7, 2011 http://www.equifax.com/PR/pdfs/CommercialFactSheetFN3810.pdf
11. Don Bradley and Chris Cowdery, “Small Business: Causes of Bankruptcy,” July 26, 2004, accessed October 7, 2011,www.sbaer.uca.edu/research/asbe/2004_fall/16.pdf.
12. Don Bradley and Chris Cowdery, “Small Business: Causes of Bankruptcy,” July 26, 2004, accessed October 7, 2011,www.sbaer.uca.edu/research/asbe/2004_fall/16.pdf
13. Anita Campbell, “Business Failure Rates Is Highest in First Two Years,” Small Business Trends, July 7, 2005, accessed October 7, 2011,smallbiztrends.com/2005/07/business-failure-rates-highest-in.html
14. T. C. Carbone, “The Challenges of Small Business Management,” Management World 9, no. 10 (1980): 36.
15. John Argenti, Corporate Collapse: The Causes and Symptoms (New York: McGraw-Hill, 1976), 45.
16. Graham Beaver, “Small Business: Success and Failure,” Strategic Change 12, no. 3 (2003): 115–22.
17. Sharon Nelton, “Ten Key Threats to Success,” Nation’s Business 80, no. 6 (1992): 18–24.
18. Robert N. Steck, “Why New Businesses Fail,” Dun and Bradstreet Reports 33, no. 6 (1985): 34–38.
19. G. E. Tibbits, “Small Business Management: A Normative Approach,” in Small Business Perspectives, ed. Peter Gorb, Phillip Dowell, and Peter Wilson (London: Armstrong Publishing, 1981), 105.
20. Jim Brown, Business Growth Action Kit (London: Kogan Page, 1995), 26.
21. Christopher Orpen, “Strategic Planning, Scanning Activities and the Financial Performance of Small Firms,” Journal of Strategic Change 3, no. 1 (1994): 45–55.
22. Sandra Hogarth-Scott, Kathryn Watson, and Nicholas Wilson, “Do Small Business Have to Practice Marketing to Survive and Grow?,” Marketing Intelligence and Planning 14, no. 1 (1995): 6–18.
23. Isaiah A. Litvak and Christopher J. Maule, “Entrepreneurial Success or Failure—Ten Years Later,” Business Quarterly 45, no. 4 (1980): 65.
24. Hans J. Pleitner, “Strategic Behavior in Small and Medium-Sized Firms: Preliminary Considerations,” Journal of Small Business Management 27, no. 4 (1989): 70–75.
25. Richard Monk, “Why Small Businesses Fail,” CMA Management 74, no. 6 (2000): 12.
26. Anonymous, “Top-10 Deadly Mistakes for Small Business,” Green Industry Pro19, no. 7 (2007): 58.
27. Rubik Atamian and Neal R. VanZante, “Continuing Education: A Vital Ingredient of the ‘Success Plan’ for Business,” Journal of Business and Economic Research 8, no. 3 (2010): 37–42.
28. T. Carbone, “Four Common Management Failures—And How to Avoid Them,”Management World 10, no. 8 (1981): 38–39.
29. Anonymous, “Top-10 Deadly Mistakes for Small Business,” Green Industry Pro19, no. 7 (2007): 58.
30. Rubik Atamian and Neal R. VanZante, “Continuing Education: A Vital Ingredient of the ‘Success Plan’ for Business,” Journal of Business and Economic Research 8, no. 3 (2010): 37–42.
31. Howard Upton, “Management Mistakes in a New Business,” National Petroleum News 84, no. 10 (1992): 50.
32. Rubik Atamian and Neal R. VanZante, “Continuing Education: A Vital Ingredient of the ‘Success Plan’ for Business,” Journal of Business and Economic Research 8, no. 3 (2010): 37–42.
33. Arthur R. DeThomas and William B. Fredenberger, “Accounting Needs of Very Small Business,” The CPA Journal 55, no. 10 (1985): 14–20.
34. Roger Brown, “Keeping Control of Your Credit,” Motor Transportation, April 2009, 8.
35. Arthur R. DeThomas and William B. Fredenberger, “Accounting Needs of Very Small Business,” The CPA Journal 55, no. 10 (1985): 14–20.
36. Hugh M. O’Neill and Jacob Duker, “Survival and Failure in Small Business,”Journal of Small Business Management 24, no. 1 (1986): 30–37.
37. Arthur R. DeThomas and William B. Fredenberger, “Accounting Needs of Very Small Business,” The CPA Journal 55, no. 10 (1985): 14–20.
38. Jim Everett and John Watson, “Small Business Failures and External Risk Factors,” Small Business Economics 11, no. 4 (1998): 371–90.
39. Jim Everett and John Watson, “Small Business Failures and External Risk Factors,” Small Business Economics 11, no. 4 (1998): 371–90.
40. Roger Ehrenberg, “Monitor 110: A Post Mortem—Turning Failure into Learning,” Making It!, August 27, 2009, accessed June 1, 2012,http://www.makingittv.com/Small-Business-Entrepreneur-StoryFailure.htm
41. http://www.businessweek.com/magazine/content/08_70/s0810040731198.htm | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/01%3A_Foundations_of_Business/1.02%3A_Chapter_2-_Success_and_Failure_in_Small_Businesses.txt |
Learning Objectives
1. Explain what a family business is.
2. Understand the role that family businesses play in the US economy.
3. Explain the advantages and disadvantages of family businesses.
“Family businesses are different.”[1]
There is no agreed-on definition of a family business. The percentage of ownership, the strategic control, the involvement of multiple generations, and the intention for the business to remain in the family are among the many criteria that experts use to distinguish family businesses from other types of businesses. [2] For the purposes of this chapter, however, a family business is defined as a business that is actively owned and/or managed by more than one member of the same family.[3] A family business can also be defined as the result of someone’s dream:
The story of every successful family business starts with someone who has the passion, confidence and courage to put his [or her] money where his [or her] mouth is…[These entrepreneurs] work incredibly hard, make things happen, are positive without being unrealistic and possess the resourcefulness to overcome all sorts of hurdles. They are also socially adept, capable of communicating effectively and good at inspiring others…[4]
Family business owners know that their roles are different from that of shareholders in companies owned by many public investors. In addition, “[E]mployees in family businesses know the difference that family control makes in their work lives, the company culture, and their career. Marketers appreciate the advantage that the image of a family business presents to customers, and families know that being in business together is a powerful part of their lives.”[5]
Market and Employment Presence
Because of the private nature of most family businesses, it is difficult to obtain accurate information about them.[6] Complicating the situation is that most data sources do not distinguish between small family businesses, such as the local pizza parlor or deli, and large family businesses, such as Walmart, Mars, and Ford. “The reality is that family-based operations are represented across the full spectrum of American companies, from small businesses to large corporations.”[7]. Within this context, the following has been observed:
• Family businesses account for a staggering 50 percent of the gross domestic product (GDP).
• Although it may seem that this GDP contribution comes from thousands of small operations, 35 percent of the Fortune 500 companies are family companies.
• Family businesses account for 60 percent of US employment and 78 percent of the new jobs created.
• Family businesses represent one of the fastest growing sectors of the economy because their new job requirements outpace their current employment rates when compared to other types of businesses.
What this means is that family businesses continue to be a powerful economic force, no matter what their size and no matter how they are defined. “Family firms are the most common form of business structure; they employ many millions of people; and they generate a considerable amount of the world’s wealth.”[10]
The focus of this chapter is on the small family business.
Video Link 3.1: Mother and Daughter Partner in Family Business
A mother and daughter partner in a hair brush business.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=36
Advantages and Disadvantages of the Family Business
There are benefits to a family business, but there are disadvantages that must be considered as well. Starting a family business is not for everyone.
Advantages
A family business offers the following advantages:
• One of the popular misconceptions about family businesses is that they are unable to adapt easily to increasing competitiveness and technological progress. The reality is that family businesses frequently have the advantage of entrepreneurial spirit, flexibility, and opportunism.[11]
• It is believed by some that family firms are “too soft” and rarely reach their potential. The reality is that family businesses actually outperform public companies. Oftentimes, the marketplace forces public companies to make short-term decisions, whereas a family business has the advantage of having more freedom to make its decisions. Family businesses can adapt to market fluctuations more easily because they can afford to be patient. They have common goals, shared values, and a commitment to brand building.[12]
• Family-owned businesses are often seen as ideal because family members form a “grounded and loyal foundation” for the company, and family members tend to exhibit more dedication to their common goals. “Having a certain level of intimacy among the owners of a business can help bring about familiarity with the company and having family members around provides a built-in support system that should ensure teamwork and solidarity.”[13]
• The culture of a family business is very different from that of a company you will find on Wall Street. “Family businesses frequently take a very long-term point of view. They’ll make investments that they don’t expect to pay off for 5 or 15 or 25 years…Culture in a family business is more frequently based on very personal and emotional values. It’s stronger because there are deeper roots and closer connections to the history of the company.”[14]
• Family businesses are becoming more and more attractive to undergraduate business students who face a bleak job and salary outlook for new grads. These undergrads are choosing to return to their family businesses directly after graduation instead of trying to find a job in corporate America or on Wall Street.[15]
• There is a common misperception that family businesses are less professional and rigorous in their behavior because of the relational nature of the businesses.[16] However, like all other businesses, family businesses face global competition and rapidly changing markets. This creates more pressure on those who join to make sure that they produce. “This emphasis on professionalism has made family businesses both more daunting and more attractive—and has created new interest in them, from family members, outsiders, and business school students.”[17]
• Many family-owned businesses tend to be stable and optimistic, even when economic times are uncertain. They seem to be better able to weather economic difficulties and stabilize the economy than their nonfamily counterparts.[18] However, this is a function of the industry and the size of the business.
• In general, family businesses feel that they are stronger because family members are involved in their activities. Family owners believe that their family members can be trusted, will work harder, and care more.[19]. This can help create competitive advantage in the marketplace.
• Family businesses may be more open to flexible or part-time schedules or choosing your hours. This presents a very attractive work environment for people who need to tend to children, parents, or other family members in need.[20]
• Family businesses tend to operate more ethically. In fact, many family businesses believe that their ethical standards are more stringent than those of their competitors. In addition, family businesses are often deeply embedded in their communities, and this proximity is seen as an important factor that increases the likelihood of ethical decision making and moral behavior.[21] As members of the local community, any ethical problems with a family business will be quickly visible.
• Family businesses also exhibit more social responsibility than their competitors. This has been attributed to their concern about image and local reputation[22] as well as their closeness to the community.
• Family businesses may incur lower costs because of the greater willingness of family members to make financial sacrifices for the sake of the business. Accepting lower pay than they would get elsewhere to help the business in the longer term or deferring wages in a cash-flow crisis are examples of family altruistic behavior.[23]
• Family businesses, in general, have greater independence of action because they have less (or no) pressure from the stock market and less (or no) takeover risk.[24]
• Family businesses tend to be more resilient in hard times because they are willing to plow profits back into the business. [25]
• Family businesses are less bureaucratic and less impersonal, which allows for greater flexibility and quicker decision making. [26]
• Family businesses offer the possibility of great financial success.[27] This can manifest itself in interesting ways. “As the family of a media conglomerate once mentioned, ‘The name I have has certainly helped me to get access to top executives of companies, persons who under other circumstances would have kept their doors shut.’” [28]
• Family members have the chance to learn the business early. This extensive expertise can create an important competitive advantage.[29] “One executive recalled how as a child he would take long walks with his father, during which they would visit stores to look at competitor’s products. Afterwards, his father would ask him which products he liked most, and this would lead to lengthy arguments about each product’s quality. This man felt that the expertise he gained during those informal outings proved invaluable later in life.”[30]
Video Link 3.2: Iron Horse Barbecue
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=36
A family-owned business that is helping other business fire up businesses of their own.
Why Family Businesses Are So Special
“If family businesses are so common, how can they also be special? When Freud was asked what he considered to be the secret of a full life, he gave a three-word answer: ‘Lieben und arbeiten [to love and to work].’ For most people, the two most important things in their lives are their families and their work. It is easy to understand the compelling power of organizations that combine both. Being in a family firm affects all the participants. The role of chairman of the board is different when the company was founded by your father and when your mother and siblings sit around the table at board meetings, just as they sat around the dinner table. The job of a CEO is different when the vice president in the next office is also a younger sister. The role of partner is different when the other partner is a spouse or a child. The role of sales representative is different when you cover the same territory that your parent did twenty-five years earlier, and your grandparent twenty-five years before that. Even walking through the door on your first day of work on an assembly line or in a billing office is different if the name over the door is your own.”[31]
Disadvantages
As attractive as family businesses are on many fronts, they have the following disadvantages:
• Family businesses tend to be stable organizations. Although this is a good thing in many instances, stability can also make it difficult to change. A new, younger family member coming into the business will find tradition and structure. Changing that is not simple. The key to changing a family business lies in defining tradition in terms of the company’s core values, not in specific ways of doing things. [32]
• Family closeness can lead to sibling rivalry or problems when both the parent and the child want control. By the third or fourth generation, with many cousins possibly sharing ownership, governance can become very complicated. [33]
• There may be times when the interests of a family member conflict with the interests of the business. One family member may want to expand the business, but other family members may not share this person’s desire. The needs of the business are not in sync with the needs of the family.
• Family ties have a downside. Family members will frequently be expected to work harder, make more of a commitment, and get paid less than other employees in the business.[34]
• Family business owners may automatically promote someone from the family or give family members a job even if they do not have adequate skills for the job. A nonfamily employee may be better qualified.[35] This can cause dissension and resentment among other employees.
• Relationships between parents and children or among siblings have a tendency to deteriorate due to communication problems. “This dysfunctional behavior can result in judgments, criticism and lack of support.”[36]
• The family business may be a breeding ground for jealousies, resentment, anger, and sabotage. Family problems may spill over into the workplace.[37]
• The business may be plagued with managerial incompetence, the lack of exposure to other businesses, and the inability to separate family and work.[38]
• Some family businesses may have difficulty attracting and keeping highly qualified managers. “Qualified managers may avoid family firms due to the exclusive succession, limited potential for professional growth, lack of perceived professionalism, and limitations on wealth transfer.”[39] Succession refers to passing the business to the next generation.
• Family businesses have limited sources of external capital because they tend to avoid sharing equity with nonfamily members.[40] Having less access to capital markets may curtail growth.[41]
• Not all children of owner-managers may want to join the business. According to one study,[42] 80 percent of those who did not work in the family business did not intend to go into the business. This reluctance comes from several directions, such as the following:
• My parents would not want me to join.
• I could not work for my parents.
• There are already too many family members in the business.
• I am not interested in this particular business.
• The business is too small for me.
• The business would not allow me to use my talents.
• The business would not allow me to use my training.
• I can earn more elsewhere.
• I am not interested in a business career.[43]
In Their Own Words
Why Some Children of Owner-Managers Do Not Want to Join the Business[44]:
I see the pressure my dad is under—this does put me off slightly. I want to enjoy my job as well as enjoying life outside work.
A larger factor when working under a relative is the problem of self-worth. It is hard to feel like you are worth something when your father is an MD.
A business relationship with your father makes your family relationship harder.
I do not look to go into the family business straight away, as I feel this is giving a commitment to work there for the rest of my life.
I would join only because I am genuinely qualified, not because I am the owner’s daughter.
The difference in my father’s education and mine is a factor affecting why I have decided not to go into the business. I have more choice over what I want to do as a career, and my personal interests would not be met by my father’s company. I am sure it would not have been his choice had he had the same educational choices as me.
As much as the route into the family business is seen by outsiders as an “easy route to wealth and inheritance,” in my case it was also a liability. At 17, was I to be the fourth generation after 100 years that could not keep the company going?
• The “spoiled kid syndrome” often occurs in a family business. The business owner may feel guilty because his devotion to the business takes away from the attention he should be giving to his children. Out of a sense of guilt, he or she starts to bribe the children, “a kind of pay-off for not being available emotionally or otherwise.”[45]
• Financial strain emanating from “family members milking the business and a disequilibrium between contribution and compensation”[46] can have a significant negative impact on the business.
• Nepotism that results in the “tolerance of inept family members as managers, inequitable reward systems, [and] greater difficulties in attracting professional management”[47] can easily lead to low morale among nonfamily members of the business, and it can ultimately result in business failure.
• Family businesses frequently have a confusing organization, with “messy structure and no clear division of tasks.” Authority and responsibility lines are unclear; jobs may overlap; executives may hold a number of different jobs; and the decision-making hierarchy may be completely ignored, existing only to be bypassed.[48] This can create a dysfunctional working environment.
• Family businesses frequently have paternalistic or autocratic rule that is characterized by a resistance to change, secrecy, and the attraction of dependent personalities.[49]
Key Takeaways
• Family businesses account for 50 percent of the GDP, 60 percent of US employment, and 78 percent of the new jobs that are created.
• A family business offers both advantages and disadvantages. It is important to understand both.
Exercises
1. Jaret Coulson has returned to the family business and is very enthusiastic about expanding the business. He has identified four options: (a) expanding the antique store either at its current site or elsewhere in Charlottetown; (b) opening several similar-sized antique shops in nearby towns; (c) using the Internet to expand sales; and (d) expanding the sales of refinished chairs in a local store to a regional furniture chain. Any one of these ideas would represent a change from his father’s Mr. Coulson’s business model. Given that he had not expressed any interest in the management of the business, how should he go about approaching his father with these ideas? If the company expands, should Jaret approach his sister and her husband about taking a more active role in the business? What should their roles be?
Family Business Issues
Learning Objectives
1. Explain why communication, employing family and non-family members, professional management, employment qualifications, salaries and compensation, succession, and ethics are important issues for all family businesses.
Looking at the vision and hard work of the founders, family businesses “take on their unique character as new members of the family enter the business. At best, the environment can be inspiring and motivating. At worst, it can result in routine business decisions becoming clouded by emotional issues.”[50]
The owners and managers of family businesses face many unique challenges. These challenges stem from the overlap of family and business issues and include communication, employing family and non-family members, professional management, employment qualifications, salaries and compensation, and succession.
Communication
Communication is important in any business, but the complexities of communication in a family business are particularly problematic. Experts say that communication is one of the most difficult parts of running a family business.[51] The approach to communication needs to include commitment, the avoidance of secrecy, and an understanding of the risks of bad communication.
Commitment
In a family business, it is critical that there be a commitment to communicate effectively with family and non-family members of the business. “Business leaders should be open about their awareness of the potential for communication issues to evolve and their willingness to accept feedback and input from all employees about opportunities for improvement and areas of concern.”[52]
One important issue is whether there should be a line drawn between family and business discussions. Some suggest that setting up strict guidelines from the start that draw a clear line between the different types of discussions is a good approach.[53] By contrast, the Praxity Family Business Survey[54] found that it is considered OK to talk about the business anywhere and at any time, whether at work or at home:
• Nineteen percent of the family businesses in the survey reported talking about business at home.
• Thirty-seven percent talk about it in the workplace.
• Forty-four percent talk about it when and wherever.
Secrecy
In family businesses, it is particularly important not to convey the impression that family members are more in the know than other employees. “…Even when this is not the case, the potential for the perception of exclusivity may exist. Steps should be taken to address any issues that may arise openly, honestly, and without preference for family members.”[55]
Risks of Bad Communication
If good communication channels are not in place, the following can occur:
• “Family members assume they know what other family members feel or want.”
• “Personal ties inhibit honest opinions being expressed.”
• “The head of the family may automatically assume control of the business even if they don’t have the best business skills.”
• “One family member ends up dominating the business.”
• “Family-member shareholders not active in the business fail to understand the objectives of those who are active and vice versa.”
• “Personal resentments become business resentments and vice versa.”[56]
These difficulties can be overcome if the family business makes a concerted effort to create and maintain an environment of open communication where people feel comfortable voicing opinions and concerns. It is important that family and non-family members have an equal opportunity to express their views.
Employing Family and Non-family Members
It is natural for a family business to employ family members, especially in management positions. Family members tend to be the first people hired when a small business gets started, and as the business grows, so do their roles.[57] There are both pros and cons to hiring family members. Both need to be considered carefully. Who to hire may well be the biggest management challenge that a family business owner faces.
Pros
On the positive side of things, several advantages can be identified for hiring family members:
• Improved customer relations through family contact
• Intergenerational continuity
• Long-term stability
• Shared values
• Loyalty and commitment
• Inherent trust
• Willingness to sacrifice for the business
• Emotional attachment to the business; more willing to contribute to its success
• Share the same culture
“A family whose members work well together can also give the business a welcoming and friendly feel. It can encourage employees who aren’t in the immediate family to work harder to gain acceptance by those employees who are.”[60]
Cons
There are also quite a few disadvantages to hiring family members:
• Families are not perfect, so a dispute among family members can spill from home into the workplace.
• There is always the possibility of managerial incompetence
• It may not be possible to separate family and work
• Patterns of conflict will be rooted in early family experiences
• Communication may break down
• Sibling rivalry may create problems
• Newly hired family members may feel that they do not have to earn their positions; their success will be seen as linked to their name instead of their abilities.
• The company may be subject to charges of discriminatory hiring practices if job openings are not published.
• Non-family members of the business may feel that family members get hiring preference.
• Non-family members may feel that they will be automatically outvoted in decision making.
• Hiring primarily family members for management positions may lead to hiring suboptimal people who cannot easily be dismissed. This could lead to greater conflict because of promotion criteria that are not based on merit.
Hiring Non-family Members
There will be times when the better decision may be to hire a non-family person for a particular job. Experience has shown that a family business is less likely to be successful if it employs only family members; bringing in the fresh thinking that comes with external expertise can be valuable at all levels of a business. [65] In addition, non-family members can offer stability to a family business by offering a fair and impartial perspective on business issues. The challenge is in attracting and retaining non-family employees because these employees “may find it difficult to deal with family conflicts on the job, limited opportunities for advancement, and the special treatment sometimes accorded family members. In addition, some family members may resent outsiders being brought into the firm and purposely make things unpleasant for non-family employees.” [66]
Because it is likely that a growing family business will need to hire people from the outside, it is important that the business come to terms with that necessity. Policies and procedures can help with the transition, but the most important thing is to prepare the family culture of the business to accept a non-family member. Not surprisingly, this is much easier said than done.
Professional Management
The decision to hire a professional manager is likely one of the most important and difficult hiring decisions that a family business owner will have to make. “A typical argument…is that professional non-family managers should be brought in to provide ‘objectivity’ and ‘rationality’ to the family firm.” There are several problems with this way of thinking. First, it perpetuates the outdated notion that family members are not professional, that the smartest thing for a family business to do is to bring in professional management—as quickly as possible. [67]
Second, professional managers are not always prepared to deal with the special nature of family-owned businesses. “The influence of families on businesses they own and manage is often invisible to management theorists and business schools. The core topics of management education—organizational behavior, strategy, finance, marketing, production, and accounting—are taught without differentiating between family and non-family businesses.” [68] This does an injustice to the unique workings of a family-owned business.
Third, a professional manager from the outside is not always prepared, perhaps not even most of the time, to deal with the special nature of family companies. The dominant view on professional management downplays the importance of the social and the cultural context. “This is a problem in family firms where family relations, norms, and values are crucial to the workings and development of the business.”[69] It is argued that the meaning business families attach to their businesses is guided by family values and expectations—so much so that “anything or anyone that interrupts this fragility could send the business into chaos.”[70]
The hiring of an outside manager, therefore, should include an assessment of both formal competence: formal education, training, and experience outside the family business and cultural competence: an understanding of the culture of a specific firm. Although it is certainly helpful and appropriate, formal competence is not sufficient for managerial effectiveness. It needs to be supplemented with cultural competence, an understanding of the culture of a specific firm. Interestingly, most family businesses look only to formal competence when selecting a CEO. [71]
Culture and Non-family CEOs
It is extremely important to understand the culture of the family firm. It means that as a leader you have to be sensitive to the organization’s reactions on the things you say and do. I have a long-term employee on my management team, and she is my guide in these issues. She can tell me how the organization will react and how things are likely to be received. We have to build on the past even though we have to do a lot of things in new and different ways. But because of the culture, this might be very sensitive (The words of a non-family CEO in a family business).
As a non-family CEO, you have to have in-depth respect for the invisible forces among the employees in the family firm. You cannot escape the fact that there will always be special bonds between the family firm and the owner. Always (The words of a non-family CEO in a family business). [72]
One concern of family businesses may be that the hiring of a non-family manager will result in the loss of their “familiness.” However, one study found that, even with non-family managers, bringing non-family management activities, styles, and characteristics, “[T]he special and unique aspects and forces of the system of the family, its individual family members, and the business itself provide a synergistic force that offsets the outside influences of the [non-family managers].” This same study acknowledged, however, that their research did not focus on understanding at what point, or percentage of non-family members, the feeling of “familiness” will begin to erode. [73]
Employment Qualifications
One of the more difficult challenges that a family business must face is determining employment qualifications for employees, both family and non-family. The lack of a clear employment policy and process can lead to major conflicts in the company. Unfortunately, it would appear that, despite their benefit, most family businesses have a family employment policy.[74]. As a result, many family businesses may end up with more employees from the family than the company needs, and some of these people may not even be qualified or suitable for the jobs they have been given. “Some family businesses even find themselves acquiring businesses that have no relationship with their original business or keeping some unprofitable business lines just to make sure that everybody in the family gets a job within the company.”[75]. This kind of situation benefits no one.
A written family-business employment policy can solve a myriad of problems because it spells out the specific terms for family and non-family members with respect to recruiting, hiring, promoting, compensating, and terminating. One recommendation is that an ideal family employment policy should include the following:[76]
• “Explain the family employment policy’s purpose and philosophy.”
• “Describe how family members will apply and be considered for positions.”
• “Cover the general conditions of employment, including compensation and supervision.”
• “Outline the approach to be taken in developing and promoting family business members.”
• Make clear that family members will be completing the same applications that other candidates will complete.
• Include an inspiring and upbeat reminder that the policy’s purpose is to help the family business succeed and to support, develop, and motivate family members to lead successful and productive lives.
• Have all family business owners sign the policy, indicating they have read and agreed to it.
Others have recommended “that family members meet three qualifications before they are allowed to join the family business on a permanent basis: an appropriate educational background; three to five years’ outside work experience; and an open, existing position in the firm that matches their background.”[77]
There are no rules that dictate the content of a family business employment policy, so differences from one family business to another can be expected. However, it is very important “to set employment conditions that do not discriminate against or favor family members. This would help establish an atmosphere of fairness and motivation for all employees of the family business.”[78]
The benefits of an employment policy notwithstanding, the idea may be met with resistance. There may be the feeling that hiring decisions for family members should be separate from the hiring decisions for non-family members because being a family member provides special qualifications that cannot be matched by someone outside the family. How to proceed will ultimately fall on the shoulders of the family business owner.
Salaries and Compensation
As difficult as hiring decisions may be for the family business, decisions about salaries and compensation are probably even worse. No matter how well intentioned and well designed the company’s compensation plan may be, there will still be jealousies, hard feelings, severed sibling relationships, and even lawsuits, particularly among those family members who feel they have been treated unfairly. [79] This presents a daunting challenge: how to develop a compensation plan that will be fair to family members and good for the business:
One of the greatest struggles of operating a family business is separating the family from the business. Oh yes, there are many great benefits to having family in the business and to being a family member in a family business, but the most difficult problems result when “family values” and issues take over, leaving business values and needs wanting. There is no greater source for family business problems—nor more fertile ground for their cure—than the family business compensation systems. [80]
Some of the Problems
Family businesses often make several common mistakes when developing their compensation plans.
• They consider fair compensation to be equal compensation for all family members, sometimes even for the owner. This creates a very sticky situation because all family members are not created equal. “It is sometimes difficult to assess and compare the talents of family members who are also employees. Nor do all family members contribute equally to the business. As a result of the stress that this causes, many family business owners ignore the problem and let compensation become a breeding ground for dissension in the family.”[81]
• They do not compensate wives for the work they do. The reason often given? It saves on taxes. Not surprisingly, this approach leaves wives isolated from the business, invisible in the decision-making process, and unappreciated. This problem extends to the compensation of sons and daughters as well. A survey by Mass Mutual Insurance Company [82] reported a big discrepancy among the salaries of sons and daughters in family businesses across America. The average salary of the typical son in a family business was \$115,000, while his sister earned only \$19,000. This may be due to the tendency of sons being groomed for leadership, while daughters are groomed for the supportive roles that command lower salaries.
• The compensation for family members is higher than that for non-family members, but the differential is not tied to the actual job requirements or performance. This situation can lead to anger, reduced motivation, resentment, and eventual departure of the non-family member from the firm.
• The business overpays family members—for a variety of reasons:[83]
• “Guilt, because mom & pop were so busy working when the kids were young.”
• “Fear of conflict, because someone’s wife threatens not to come to the family picnic.”
• “Resistance to change, because ‘That’s the way we’ve always done it.’”
• “Inability to confront family members who feel ‘entitled’ to inflated salaries.”
• “Determination to minimize estate taxes by transferring wealth through compensation.”
• Emotional pressures are allowed to determine compensation policies. What this means is that compensation is not correctly determined by job requirements and performance in those jobs. When this happens, small problems develop centrifugal force:[84]
• “Fighting between sibling/cousin partners increases.”
• “Hard-working family members and employees lose morale.”
• “Well-motivated competent employees leave the company.”
• “The company loses its competitive edge and growth potential.”
• “Family harmony decreases.”
• “The value of the company declines, or it is sold—for the wrong reasons.”
Some of the Solutions
Developing a fair compensation plan for the family business is not easy. It requires good faith, trust, and good business sense. The dollar amounts offered to family members will be critical, but the more pressing issue is fairness. [85] Unfortunately, fairness is often construed as equality. This must be avoided.
There is no template for designing a compensation plan for family businesses, but there are several recommendations:[86]
• Develop accurate job descriptions for each employee that include responsibilities, level of authority, technical skills, level of experience and education required for the job, and goals for an annual performance review. In a performance-based company, the amount of stock owned by a family member will not be related to his or her compensation.
• Develop a clear philosophy of compensation so that everyone understands the standards that are used to pay people. The following is a sample of a written compensation plan philosophy that was developed by one family.
Family members employed in the business will be paid according to the standards in our region, as reported by our trade association, for a specific position, in companies of our size. In order to retain good employees we will pay all employed family members and other managers within the top quartile of our industry’s standards. Additional compensation will be based on success in reaching specific company goals, with bonuses shared among all members of the management team. Individual incentives will be determined according to measurable goals for job performance determined each year, and reviewed by the appropriate manager.[87]
• Gather information about the salaries of similar positions in the industry of the family business in the applicable region of the country. Look at companies that are similar in the number of employees, revenue, and product. If possible, obtain salary and benefit information.
• Have the base salary for each position be consistent with the salaries and wages paid for comparable positions at similarly sized businesses. Paying at this market value will have an excellent effect on non-family members because they will feel that they are on an even playing field. There will be a positive effect on business morale.
• The family business owner might consider seeking outside help in determining compensation levels for individual family members. However, this assistance must be seen as truly objective, with no reason to favor one viewpoint over another.
Oh, Those Sleepless Nights!
A recent family business survey reported that the following things keep family business owners awake at night. [88]
Table 3.1 Top Factors Business Owners Lose Sleep Over
Rank The Nightmare Percentage Citing as a Significant Concern (%)
1 Family members can never get away from work. 18
2 Business disagreements can put strain on family relationships. 17
3 Emotional aspects can get in the way of important business decisions. 16
4 Transition to the next generation is more difficult than a third-party sale. 10
5 There can often be conflicts regarding the fairness of reward for effort. 9
6 The business rewards are not necessarily based on merit. 8
7 Family members find it difficult to be individuals in their own right. 5
8 Difficulties arise in attracting professional management. 5
9 Children can be spoiled through inequitable rewards. 4
10 Outside shareholders do not contribute but take payouts from the business. 3
11 The family is always put before the business and therefore can be less efficient. 3
12 Past deeds are never forgotten and are brought up at inappropriate times. 2
Other urgent issues identified by a different family business survey included, in order of importance, the following:[89]
• Labor costs
• Health-care costs
• Finding qualified employees
• Foreign competition
• Labor union demands
• Domestic competition
• Oil prices
• Availability of credit from lenders
• Estate taxes
Succession
Another important issue that is particularly difficult for family businesses is succession. As mentioned earlier in this chapter, succession is about passing the business to the next generation. Decisions have to be made about who will take over the leadership and/or ownership of the company when the current generation dies or retires [90]. Interestingly, “only a third of all family businesses successfully make the transition to the second generation largely because succeeding generations either aren’t interested in running the business or make drastic changes when they take the helm.”[91]. There are family businesses that manage the transition across generations quite easily because the succession process chooses only the children willing and able to join and work with the prevailing family, business values, and goals. Unfortunately, there are also instances in which children have had to leave school as soon as legally allowed, not equipped to manage either the business, their lives, or their family. These children spend many resentful years in the business until it fails.[92]
Passing the family business to the next generation is a difficult thing to do, but succession is a matter of some urgency because 40 percent of US businesses are facing the issue of succession at any given point in time. [93]
This urgency notwithstanding, there are several forces that act against succession planning:[94]
1. Founder
• Fear of death
• Reluctance to let go of power and control
• Personal loss of identity
• Fear of losing work activity
• Feelings of jealousy and rivalry toward successor
2. Family
• Founder’s spouse’s reluctance to let go of role in firm
• Norms against discussing family’s future beyond lifetime of parents
• Norms against favoring siblings
• Fear of parental death
3. Employees
• Reluctance to let go of personal relationship with founder
• Fears of differentiating among key managers
• Reluctance to establish formal controls
• Fear of change
4. Environmental
• Founder’s colleagues and friends continue to work
• Dependence of clients on founder
• Cultural values that discourage succession planning
These are powerful forces working against succession planning, but they need to be overcome for the good of the founder, the family, and the business. It will be tricky to balance the needs of all three and fold them into a good succession plan.
The Succession Plan
Voyageur Transportation, a company in London, calls its successful succession planning program, “If you got hit by a beer truck, what would happen to your department?”[95]. As a family business owner, you should pose this question in terms of yourself and your business. Hopefully, this will provide the impetus you need to develop a succession plan.
A good succession plan outlines how the succession will occur and what criteria will be used to judge when the successor is ready to take on the task. It eases the founder’s concerns about transferring the firm to someone else and provides time in which to prepare for a major change in lifestyle. It encourages the heirs to work in the business, rather than embarking on alternative careers, because they can see what roles they will be able to play. And it endeavors to provide what is best for the business; in other words, it recognizes that managerial ability is more important than birthright, and that appointing an outside candidate may be wiser than entrusting the company to a relative who has no aptitude for the work.
A good succession plan will recognize and accept people’s differences, not assume that the next generation wants the business; determine if heirs even have enough experience to run the business; consider fairness; and think and act like a business. The plan should also include a timetable of the transition stages, from the identification of a successor to the staged and then full transfer of responsibilities, and a contingency plan in case the unforeseen should happen, such as the departure or death of the intended successor or the intended successor declining the role.[97] It would also be helpful to get some good professional advice—from company advisors who have expertise in the industry as well as other family-run businesses.[98]
Although each succession plan will be different, the following components should be seen as necessary for a good succession plan:[99]
1. Establish goals and objectives. As the family business owner, you must establish your personal goals and vision for the business and your future role in its operation. You should include your retirement goals, family member goals, goals of other stakeholders (e.g., partners, shareholders, and employees), and goals relating to what should happen in the case of your illness, death, or disability.
2. Family involvement in the decision-making process. If the family and stakeholders who are involved in the decision-making process are kept informed of the decisions being made, many of the problems related to inheritance, management, and ownership issues will be alleviated. Communication, the process for handling family change and disputes, the family vision for the business, and the relationship between the family and the business should be addressed. The surest path to family discord is developing the succession plan on your own and then announcing it.[100]
3. Identify successor(s). This section of the plan will address the issue of who takes over ownership and management of the business. Identification of the potential successor(s), training of the successor(s), building support for the successor(s), and teaching the successor(s) to build vision for the business are included here. Working with your successor(s) for a year or two before you hand over the business will increase the chances for success.[101]
4. Estate planning. Estate planning is important if you are planning to retire or want to take precautionary measures regarding the future of the business in the event you are unable to continue operation of the family business due to illness, disability, or death. You should consult a lawyer, an accountant, a financial/estate planner, and a life insurance representative so that your benefits will be maximized. You will need to consider taxation, retirement income, provisions for other family members, and active/nonactive family members.
5. Contingency planning. Contingency planning is about unforeseen circumstances. It is about strategizing for the most likely “what if” scenarios (e.g., your death or disability). By thinking in terms of the unforeseen, you will be taking a proactive rather than reactive approach.
6. Company structure and transfer methods. This section of the succession plan involves the review and updating of the organizational and structural plan for the organization taking into account the strengths and weaknesses of the successor. The following needs to be identified: the roles and the responsibilities of the successor, the filling of key positions, structuring of the business to fit the successor, the potential roles for the retiring owner, any legal complications, and financial issues.
7. Business valuation. This section is relevant only if the business is being sold. Passing the business to a family member would not involve a business valuation.
8. Exit strategy. With any succession, ownership will be transferred, and you will remove yourself from the day-to-day operations of the business. Alternatives will be compared, and a framework for making your final choices will be developed. The transfer method and the timelines are decided. The exit plan should then be published and distributed to everyone who is involved in the succession process.
9. Implementation and follow-up. The succession plan should be reviewed regularly and revised as situations change. It should be a dynamic and a flexible document.
As difficult as the planning process can be, the goal should be a succession plan that will be in the best interests of all—or most—of the parties involved. Business interests should be put ahead of family interests, and merit should be emphasized over family position.[102]
The Family Business and Technology
In 2008, when R. Michael Johnson—Mikee to everyone who knows him—took over the pressure-treated lumber company his grandfather founded in 1952, he had a great idea: laptops for all managers and sales staff.
“‘You would have thought the world was coming apart,” says Johnson, CEO and president of Cox Industries in Orangeburg, South Carolina. One salesman—convinced that the computer would be used to track his movements outside the office—up and quit. A buyer who had been with the company for thirty-five years said he would like a fax machine but could not see why he needed a computer when he had managed just fine without one for so long.
And that was just the beginning. In an industry where some businesses still write delivery tickets by hand and tote them up on calculators, Johnson recently led the company through an ERP (enterprise resource planning) software conversion and distributed iPhones to the sales team so they can use the company’s new customer relationship management (CRM) system.
“‘Let’s just say I have spent quite a few Sunday lunches after church explaining technology acronyms to Granddad and Grandmom,” Johnson says.
The resistance to new technology quieted, however, after Johnson was able to point to market share growth of 35 percent at the \$200 million business in the past year. “The numbers are starting to resonate,” he says. “Five years ago, I couldn’t even say what our market share was because we didn’t have the technology to figure it.”[103]
Key Takeaways
• Important family issues include communication, employing family and non-family members, professional management, employment qualifications, salaries and compensation, and success. Each issue can create conflict.
• It is very important to understand the culture of the family business, especially by non-family CEOs.
• Succession planning is critical to the success of passing a business to family members.
Exercises
1. Select a family business in your area. Make arrangements to speak with three members of the family who work in the business. Develop a list of ten questions that cover a broad range of issues, such as the approach to compensation (but do not ask for specific salary or wage numbers), the process for hiring family and non-family members, and the plans for passing the business to the next generation. Ask each member of the business the same questions. Pull the answers together and compare them. Where did you find similarities? Where did you find differences? Did everyone know the answer to each question? Where were people reluctant to answer? Prepare a three- to five-page report on your findings.
2. The family business is looking to expand, and some members of the family, but not all, feel that it might be worth bringing in someone from the outside to fill one of the new management positions because the family talent has been pretty much exhausted. Design a process for hiring an external manager. What things should be considered? How might you get buy-in from all family members?
Conflict
Learning Objectives
1. Explain what conflict is.
2. Explain why positive or constructive conflict can be helpful to a family business.
3. Explain why negative or destructive conflict can damage a family business.
4. Identify sources of negative conflict in a family business.
5. Identify some ways in which negative conflict can be avoided.
All businesses have conflict. It can be a good thing or it can be a bad thing. Positive conflict or constructive conflict can be beneficial to a family business when it increases opportunity recognition, produces high-quality decisions, encourages growth, strengthens groups and individuals, increases the learning necessary for entrepreneurial behavior, and increases the levels of commitment to the decisions being made. An example of positive conflict is a disagreement between family members on the strategic direction of the family business, the result being a much-needed rethinking of the business plan and a new agreed-on vision for the company.[107]
By contrast, negative or destructive conflict can hurt a business by damaging the harmony and relationships of family members in the family business, discouraging learning, causing ongoing harm to groups and individuals in the business, frustrating adequate planning and rational decision making, and resulting in poor quality decisions. “The absence of good conflict makes it that much harder to accurately evaluate business ideas and make important decisions…But conflict does not mean browbeating.”[110] An example of a negative conflict would be arguments over the successor to the business. Ultimately, the failure to adequately control negative conflict may contribute to the high mortality rate of family-owned businesses.[111]
Because of the clash between business and emotional concerns in a family business, the potential for negative conflict can be greater than for other businesses. The tension that exists among the personal lives and career pursuits of family members creates an interrole conflict. A situation when a family member has simultaneous roles with conflicting expectations (occurring when a family member has simultaneous roles with conflicting expectations) in which the role pressures from work and home are incompatible.[113] This conflict is difficult—if not impossible in some instances—to resolve. “Due to the interconnection and frequent contact among family members working in the business with those who are not but may still have an ownership stake, recurring conflict is highly probable in family firms.”[114]
Sources of Conflict
The specific causes of conflict in a family business are many. Because the typical understanding of conflict in family businesses is that conflict refers to negative conflict that is unhealthy and disruptive, negative conflict is the focus of this section.
The PricewaterhouseCoopers Family Business Survey[115] identified a core group of issues that are likely to cause tension.
Table 3.2 Factors Causing Tension in Family Businesses
Issue Causing Tension Causes Some Tension (%) Causes a Lot of Tension (%)
Discussion about the future strategy of the business 25 9
Performance of family members actively involved in the business 19 8
Decisions about who can and cannot work in the business 19 7
Failure of family members actively involved in the business to consult the wider family on key issues 16 7
Decisions about the reinvestment of profits in the business versus the payment of dividends 15 7
The setting of remuneration levels for family members actively involved in the business 14 7
The role in-laws should or should not play in the business 14 7
Decisions about who can and cannot hold shares in the business 13 6
Discussions about the basis on which shares in the business should be valued 12 5
Rejection of chosen successor by other family members 10 5
Add to this the fact that “[F]amily firms are prone to psychodynamic effects like sibling rivalry, children’s desire to differentiate themselves from their parents, marital discord, identity conflict, and succession and inheritance problems that non-family businesses do not suffer from,”[116] and it’s easy to see how the family business is a fertile field for negative conflict.[117]
Several other sources of conflict can occur in a family-owned business. A sampling of those sources is discussed here. All have the potential to adversely impact family relationships, business operations, and business results.
• Rivalry. Harry Levinson from the Harvard Business School maintains that, “the fundamental psychological conflict in family businesses is rivalry, compounded by feelings of guilt, when more than one family member is involved.” This rivalry can occur between father and son, siblings, husband and wife, father and daughter, and in-laws with members of the family that own the business.
• Differing vision. Family members will often disagree with the founder and with each other about the vision and strategy for the business. These differences “can create fear, anger, and destructive attempts to control decisions that are divisive and counter-productive to making and implementing sound decisions.” Rivalries that spill into the workplace can get nasty, leading to destructive behaviors.
• Jealousy. There is always the potential for jealousy in the family business. It can arise from feelings of unfairness in such things as compensation, job responsibilities, promotions, “having the ear” of the business founder, and stock distributions. It can also arise with respect to the planned successor when there is a difference of opinion about who it should be. If it is not resolved, jealousy has the potential to divide the family and destroy the business.[120]
• Succession. Succession is always a big obstacle for a family business. In some cases, the founder may feel that his or her children are not capable of running the business. This will cause obvious tension between the parent and the child/children, such that the child or children may leave the business in frustration This, in turn, becomes problematic for succession. “Who gets what type of equity, benefit, title, or role can be major sources of explicit conflict or implicit but destructive behaviors.” It is also true that while the founder of the business wants to continue family ownership and leadership of the business, this may not be true of his or her immediate family or later-generation family members This can create substantive conflict during succession planning.
• Playing by different rules. This cause of negative conflict “often presents itself as a form of elitism or entitlement that exists simply by virtue of being in a family that owns a business. Examples show up in allowing one or more family members to exhibit deficient standards of conduct or performance that violate sound business practices or important requirements that all other employees are expected to follow. Such behaviors can be divisive and demoralizing to all employees and customers as well as harmful to the reputation of the business.”[124]
• Decision making. If roles and responsibilities are not clearly defined, conflict will arise over who can make decisions and how decisions should be made. This will lead to confusion, uncertainty, and haphazard decisions that will put the company at risk.
• Compensation and benefits. “This is one of the most frequent sources of conflict, especially among members of the younger generation.” A person’s compensation is inextricably linked to his or her feelings of importance and self-worth. Compound that with the emotions associated with being a member of the family that owns the business, and you have the potential for explosive negative conflict. Clearly, this is not in the best interests of the business.[125]
Avoiding Conflict
Some measure of family squabbling is expected in a family business. Some of the arguments will be logical and necessary. However, “it’s important that they remain professional and not personal, because squabbling among family members in a work environment can make the employees and customers feel extremely uncomfortable, and can give them grounds for legal claims against the business.” The negative effects of family squabbling are as follows:[127]
• Unprofessional image. Family squabbling conjures up images of children—immaturity and pettiness. This sends a signal to customers and other employees that they are not in a professional environment that focuses on the right things.
• Uncomfortable environment. It is embarrassing to witness squabbling. No one likes to be in an awkward atmosphere; squabbling can cost you customers and employees, and it may result in expensive and unpleasant lawsuits. This can affect your bottom line very quickly.
• Discrimination. Nepotism is one of the biggest dangers of working in a family business. Arguing with relatives will only reinforce to other employees that they are in a family business. This can quickly lead to feelings of disparate treatment which, in turn, can lead to discrimination charges.
• Legal troubles. In the worst cases of family squabbling, disagreements over business can lead to lawsuits. If one family member’s role is minimized and his or her authority is restricted, this is violating the person’s rights as a shareholder. This can lead to an oppressed minority shareholder suit against the family business. This would be expensive, it would be ugly, and it could lead to the demise of the company.
Avoiding conflict is no easy feat. However, there are several things that a family business should consider. First, there are consultants who engage in conflict resolution for a living. The possibilities should be checked out. If the budget can handle the costs of a consultant, it could be the best choice. A consultant, having no reason to take one side or the other, will bring the necessary objectivity to resolution of the conflict.
Second, emotional reactions should be differentiated from problem-solving reactions. Family members need to take a professional perspective rather than that of an irritated sibling, parent, son, or daughter. It will probably be difficult to do this, but it is important that it be done.
Third, focus on the professional role instead of the family role. “Make sure it’s clear what the expectations and attitudes of all your employees are…Because you’re a small business, you might not have as strict a policy as a large corporation, but it would still be helpful to put it in writing, such as in an employee handbook, which carries legal responsibilities to both family and outside employees.”[129]
Fourth, encourage honesty from the beginning. When first starting to work together, it is important that family members sit down together to talk about potential conflicts that might arise. Acknowledging that it will be more difficult to work together because of being family is a good beginning. Treating family members and the professional environment with respect and expecting honesty when someone steps over the line should make for a smoother process.[130]
Last, the founder should try to keep the conflict constructive. This means stimulating task-oriented disagreement and debate while trying to minimize interpersonal conflicts This will require a fair decision-making process. For people to believe that a process is fair, it means that they must:[132]
• “Have ample opportunity to express their views and to discuss how and why they disagree with other [family] members”;
• “Feel that the decision-making process has been transparent, i.e., deliberations have been relatively free of secretive, behind-the-scenes maneuvering”;
• “Believe that the leader listened carefully to them and considered their views thoughtfully and seriously before making a decision”;
• “Perceive that they had a genuine opportunity to influence the leader’s final decision”; and
• “Have a clear understanding of the rationale for the final decision.”
Key Takeaways
• Conflict can be either positive or negative. Negative conflict can potentially harm the business.
• There are many sources of negative conflict in a family business. The fundamental psychological conflict in family businesses is rivalry.
• It is important to avoid negative conflict. In particular, family squabbling that is witnessed by others can cause damage to the firm. Employees and customers will feel uncomfortable, and there may ultimately be grounds for a lawsuit.
Exercises
1. The founder of Carson’s Dairy Farm in Springfield, PEI has decided to retire. He wants one of three children to take over leadership of the business—and he knows exactly who it should be. Other members of the family have their ideas as well. One segment of the family wants the oldest son, Michael, to take over, but the founder thinks Michael is a melon head. The second son, Christopher, is a well-meaning and hard-working part of the business, but he just does not have what it takes to be a leader. Nonetheless, he is favored by another group of family members. Samantha, the youngest child, is as sharp as a tack, with solid experience and accomplishments under her belt. On an objective basis, Samantha would be the best choice for the business. She is the founder’s choice to take over the company and has other family supporters as well, although not as many as for Michael or Christopher. This is a situation tailor-made for conflict. How does the founder finesse the selection of Samantha and minimize the conflict that is bound to occur? Can he win?
1. BDO 2009 Report: “Focusing on Business Families,” BDO, November 2009, accessed October 8, 2011, static.staging.bdo.defacto-cms.com/assets/documents/2010/04/Focusing_on _business_families.pdf.
2. Joseph H. Astrachan and Melissa Carey Shanker, “Family business’s Contribution to the U.S. Economy: A Closer Look,” Family Business Review 16, no. 3 (2003): 211–19.
3. “Family Businesses,” Entrepreneur, 2010, accessed October 8, 2011, http://www.entrepreneur.com/encyclopedia/term/82060.html.
4. “Making a Difference: The PriceWaterhouseCoopers Family Business Survey 2007/08,” PriceWaterhouseCoopers, November 2007, accessed October 8, 2011, http://www.pwc.com/en_TH/th/publications/assets/pwc_fbs_survey.pdf
5. Kelin E. Gersick et al., Generation to Generation: Life Cycles of the Family Business (Cambridge, MA: Owner Managed Business Institute, Harvard Business School Press, 1997), 1.
6. Joseph H. Astrachan and Shanker, “Family business’s Contribution to the U.S. Economy: A Closer Look,” Family Business Review 16, no. 3 (2003): 211–19.
7. “Family Business Statistics,” Gaebler.com: Resources for Entrepreneurs, October 10, 2010, accessed October 8, 2011, http://www.gaebler.com/Family-Business-Statistics.htm
8. “Family Business Statistics,” Gaebler.com: Resources for Entrepreneurs, October 10, 2010, accessed October 8, 2011, http://www.gaebler.com/Family-Business-Statistics.htm;
9. Stacy Perman, “Taking the Pulse of Family Business,” February 13, 2006, accessed October 8, 2011, http://www.BusinessWeek.com/smallbiz/content/feb2006/sb20060210_476491.htm.
10. “Making a Difference: The PricewaterhouseCoopers Family Business Survey 2007/08,” PriceWaterhouseCoopers, November 2007, accessed October 8, 2011, http://www.pwc.com/en_TH/th/publications/assets/pwc_fbs_survey.pdf.
11. “Myths and Realities of Family Business,” 2002, accessed October 8, 2011, http://www.insead.edu/discover_insead/publications/docs/IQ03.pdf.
12. “Myths and Realities of Family Business,” 2002, accessed October 8, 2011, http://www.insead.edu/discover_insead/publications/docs/IQ03.pdf.
13. Alexis Writing, “Pros and Cons of Family Business,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/pros-cons-family-business-409.html.
14. Margaret Steen, “The Decision Tree of Family Business,” Stanford Graduate School of Business, August 2006, accessed June 21, 2012, www-prd-0.gsb.stanford.edu/news/bmag/sbsm0608/feature_familybiz.html.
15. Alison Damast, “Family Inc.: The New B-School Job Choice,” Bloomberg BusinessWeek, April 12, 2010, accessed October 8, 2011, http://www.BusinessWeek.com/print/bschools/content/apr2010/bs20100412_706043.htm.
16. “American Family Business Survey,” Mass Mutual Financial Group, 2007, accessed October 8, 2011, http://www.massmutual.com/mmfg/pdf/afbs.pdf.
17. Margaret Steen, “The Decision Tree of Family Business,” Stanford Graduate School of Business, August 2006, accessed June 21, 2012, www-prd-0.gsb.stanford.edu/news/bmag/sbsm0608/feature_familybiz.html.
18. “American Family Business Survey,” Mass Mutual Financial Group, 2007, accessed October 8, 2011, http://www.massmutual.com/mmfg/pdf/afbs.pdf.
19. “The Family Business Survey 2008/2009,” Praxity, 2009, accessed October 8, 2011, http://praxityprod.awecomm.com/News/2009/Pages/UKFamilyBusinessSurvey.aspx
20. Alexis Writing, “Pros and Cons of Family Business,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/pros-cons-family-business-409.html.
21. “American Family Business Survey,” Mass Mutual Financial Group, 2007, accessed October 8, 2011, http://www.massmutual.com/mmfg/pdf/afbs.pdf.
22. “American Family Business Survey,” Mass Mutual Financial Group, 2007, accessed October 8, 2011, http://www.massmutual.com/mmfg/pdf/afbs.pdf.
23. “Advantages of Family Businesses,” Business Link, accessed October 8, 2011, http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073792650&type= RESOURCES.
24. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
25. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
26. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
27. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
28. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
29. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
30. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
31. Kelin E. Gersick et al., Generation to Generation: Life Cycles of the Family Business (Cambridge, MA: Owner Managed Business Institute, Harvard Business School Press, 1997), 2–3.
32. Margaret Steen, “The Decision Tree of Family Business,” Stanford Graduate School of Business, August 2006, accessed June 21, 2012, www-prd-0.gsb.stanford.edu/news/bmag/sbsm0608/feature_familybiz.html.
33. Margaret Steen, “The Decision Tree of Family Business,” Stanford Graduate School of Business, August 2006, accessed June 21, 2012, www-prd-0.gsb.stanford.edu/news/bmag/sbsm0608/feature_familybiz.html.
34. “The Family Business Survey 2008/2009,” Praxity, 2009, accessed October 8, 2011, http://praxityprod.awecomm.com/News/2009/Pages/UKFamilyBusinessSurvey.aspx
35. Alexis Writing, “Pros and Cons of Family Business,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/pros-cons-family-business-409.html.
36. Alexis Writing, “Pros and Cons of Family Business,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/pros-cons-family-business-409.html.
37. “Advantages and Disadvantages of a Family Business,” September 6, 2009, accessed October 8, 2011, pinoynegosyo.blogspot.com/2009/09/advantages-and -disadvantages-of-family.html.
38. “Advantages and Disadvantages of a Family Business,” September 6, 2009, accessed October 8, 2011, pinoynegosyo.blogspot.com/2009/09/advantages-and -disadvantages-of-family.html.
39. David G. Sirmon and Michael A. Hitt, “Managing Resources: Linking Unique Resources, Management, and Wealth Creation in Family Firms,” Entrepreneurship Theory and Practice, Summer 2003, 339–58.
40. David G. Sirmon and Michael A. Hitt, “Managing Resources: Linking Unique Resources, Management, and Wealth Creation in Family Firms,” Entrepreneurship Theory and Practice, Summer 2003, 339–58.
41. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
42. Sue Birley, “Attitudes of Owner-Managers’ Children towards Family and Business Issues,” Entrepreneurship Theory and Practice, Spring 2002, 5–19.
43. Sue Birley, “Attitudes of Owner-Managers’ Children towards Family and Business Issues,” Entrepreneurship Theory and Practice, Spring 2002, 5–19.
44. Sue Birley, “Attitudes of Owner-Managers’ Children towards Family and Business Issues,” Entrepreneurship Theory and Practice, Spring 2002, 5–19.
45. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
46. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
47. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
48. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
49. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good and the Bad News,” Organizational Dynamics 21, no. 3 (1993): 59–71.
50. “Focusing on Business Families,” BDO, November 2009, accessed October 8, 2011, static.staging.bdo.defacto-cms.com/assets/documents/2010/04/Focusing_on _business_families.pdf.
51. Christine Lagorio, “How to Run a Family Business,” Inc., March 5, 2010, accessed October 8, 2011, http://www.inc.com/guides/running-family-business.html.
52. Leigh Richards, “Family Owned Business and Communication,” Chron.com, 2010, accessed June 1, 2012, http://smallbusiness.chron.com/family-owned -business-communication-3165.html.
53. Leigh Richards, “Family Owned Business and Communication,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/family-owned-business -communication-3165.html
54. “The Family Business Survey 2008/2009,” Praxity , 2009, accessed October 8, 2011, http://praxityprod.awecomm.com/News/2009/Pages/UKFamilyBusinessSurvey.aspx .
55. Leigh Richards, “Family Owned Business and Communication,” Chron.com, 2010, accessed October 8, 2011, smallbusiness.chron.com/family-owned-business -communication-3165.html.
56. “Communication and Family Businesses,” Business Link, 2010, accessed October 8, 2011, http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId= 1073792652.
57. Philip Keefe, “Hiring Family Members for the Family Business,” March 30, 2010, accessed October 8, 2011, philip-keeffe.suite101.com/hiring-family-members-for-the -family-business-a220028
58. Dean Fowler and Peg Masterson Edquist, “Evaluate the Pros and Cons of Employing Family Members,” Business Journal, June 6, 2003, accessed October 8, 2011, http://www.bizjournals.com/milwaukee/stories/2003/06/09/smallb6.html
59. Philip Keefe, “Hiring Family Members for the Family Business,” March 30, 2010, accessed October 8, 2011, philip-keeffe.suite101.com/hiring-family-members-for-the-family -business-a220028.
60. Philip Keefe, “Hiring Family Members for the Family Business,” March 30, 2010, accessed October 8, 2011, philip-keeffe.suite101.com/hiring-family-members-for-the -family-business-a220028.
61. Dean Fowler and Peg Masterson Edquist, “Evaluate the Pros and Cons of Employing Family Members,” Business Journal, June 6, 2003, accessed October 8, 2011, http://www.bizjournals.com/milwaukee/stories/2003/06/09/smallb6.html
62. Philip Keefe, “Hiring Family Members for the Family Business,” March 30, 2010, accessed October 8, 2011, philip-keeffe.suite101.com/hiring-family-members-for-the-family-business -a220028
63. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69
64. Margaret Steen, “The Decision Tree of Family Business,” Stanford Graduate School of Business, August 2006, June 21, 2012, www-prd-0.gsb.stanford.edu/news/bmag/sbsm0608/feature_familybiz.html.
65. “Focusing on Business Families,” BDO, November 2009, accessed October 8, 2011, static.staging.bdo.defacto-cms.com/assets/documents/2010/04/Focusing_on _business_families.pdf
66. “Family Owned Businesses Law and Legal Definition,” USLegal.com, 2010, accessed October 8, 2011, definitions.uslegal.com/f/family-owned-businesses.
67. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69.
68. Kelin E. Gersick et al., Generation to Generation: Life Cycles of the Family Business (Cambridge, MA: Owner Managed Business Institute, Harvard Business School Press, 1997), 4
69. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69
70. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69.
71. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69.
72. Annika Hall and Mattias Nordqvist, “Professional Management in Family Businesses: Toward an Extended Understanding,” Family Business Review 21, no. 1 (2008): 51–69.
73. Matthew C. Sonfield and Robert N. Lussier, “Family-Member and Non-family-Member Managers in Family Businesses,” Journal of Small Business and Enterprise Development 16, no. 2 (2009): 196–209.
74. “GARBAGE IN—GARBAGE OUT: Family Employment Policies,” ReGENERATION Partners, May 2002, accessed October 8, 2011, http://www.regeneration-partners.com/artman/uploads/20-2002-may-news.pdf
75. “Family Member Employment Policies (Case Study 1: SABIS),” IFC Corporate Governance, 2006, accessed October 8, 2011, http://www.smetoolkit.org/smetoolkit/en/content/en/6742/Family-Member-Employment-Policies-Case-Study-1 -SABIS%C2%AE-
76. “GARBAGE IN—GARBAGE OUT: Family Employment Policies,” ReGENERATION Partners, May 2002, accessed October 8, 2011, http://www.regeneration-partners.com/artman/uploads/20-2002-may-news.pdf.
77. Craig E. Aronoff and John L. Ward, Family Business Succession: The Final Test of Greatness (Marietta, GA: Business Owner Resources, 1992), as cited in “Nepotism,” Reference for Business.com, 2010, accessed October 8, 2011, http://www.referenceforbusiness.com/small/Mail-Op/Nepotism.html.
78. “Family Member Employment Policies (Case Study 1: SABIS),” IFC Corporate Governance, 2006, accessed October 8, 2011, http://www.smetoolkit.org/smetoolkit/en/content/en/6742/Family-Member-Employment-Policies-Case-Study-1-SABIS%C2% AE-.
79. “Family Owned Businesses: Compensation in Family Businesses,” Gaebler.com Resources for Entrepreneurs, 2010, accessed October 8, 2011, http://www.gaebler.com/Compensation-in-Family-Businesses.htm
80. Bernard J. D’Avella Jr. and Hannoch Weisman, “Why Compensation for Family Members Should Be at Market Value,” Fairleigh Dickinson University, 2010, accessed October 8, 2011, view.fdu.edu/default.aspx?id=2344
81. Kathy Marshack, “How to Arrive at Fair Compensation in a Family Business,” American Chronicle, February 29, 2008, accessed October 8, 2011, http://www.americanchronicle.com/articles/view/53757
82. Referenced in Kathy Marshack, “How to Arrive at Fair Compensation in a Family Business,” American Chronicle, February 29, 2008, accessed October 8, 2011, http://www.americanchronicle.com/articles/view/53757.
83. Ellen Frankenberg, “Equal Isn’t Always Fair: Making Tough Decisions about Transmitting Family Assets,” Frankenberg Group, 2010, accessed October 8, 2011, http://www.frankenberggroup.com/equal-isnt-always-fair-making-tough-decisions-about -transmitting-family-assets.html.
84. Ellen Frankenberg, “Equal Isn’t Always Fair: Making Tough Decisions about Transmitting Family Assets,” Frankenberg Group, 2010, accessed October 8, 2011, http://www.frankenberggroup.com/equal-isnt-always-fair-making-tough-decisions-about -transmitting-family-assets.html.
85. Dean Fowler and Peg Masterson Edquist, “Evaluate the Pros and Cons of Employing Family Members,” Business Journal, June 6, 2003, accessed October 8, 2011, http://www.bizjournals.com/milwaukee/stories/2003/06/09/smallb6.html
86. Bernard J. D’Avella Jr. and Hannoch Weisman, “Why Compensation for Family Members Should Be at Market Value,” Fairleigh Dickinson University, 2010, accessed October 8, 2011, view.fdu.edu/default.aspx?id=2344.
87. Ellen Frankenberg, “Equal Isn’t Always Fair: Making Tough Decisions about Transmitting Family Assets,” Frankenberg Group, 2010, accessed October 8, 2011, http://www.frankenberggroup.com/equal-isnt-always-fair-making-tough-decisions-about -transmitting-family-assets.html.
88. “The Family Business Survey 2008/2009,” Praxity, 2009, accessed October 8, 2011, http://praxityprod.awecomm.com/News/2009/Pages/UKFamilyBusinessSurvey.aspx.
89. “American Family Business Survey,” Mass Mutual Financial Group, 2007, accessed October 8, 2011, http://www.massmutual.com/mmfg/pdf/afbs.pdf.
90. “Family Owned Businesses Law and Legal Definition,” USLegal.com, 2010, accessed October 8, 2011, definitions.uslegal.com/f/family-owned-businesses
91. “Family Business Statistics,” Gaebler.com: Resources for Entrepreneurs, October 10, 2010, accessed October 8, 2011, http://www.gaebler.com/Family-Business-Statistics.htm
92. Sue Birley, “Attitudes of Owner-Managers’ Children Towards Family and Business Issues,” Entrepreneurship Theory and Practice, Spring 2002, 5–19.
93. Nancy Bowman-Upton, “Transferring Management in the Family-Owned Business,” Small Business Administration, 1991, accessed October 8, 2011, http://www.sbaonline.sba.gov/idc/groups/public/documents/sba_homepage/serv_sbp _exit.pdf.
94. Ivan Lansberg, “The Succession Conspiracy,” Family Business Review 1 (1981): 119–44, as cited in Nancy Bowman-Upton, “Transferring Management in the Family-Owned Business,” Small Business Administration, 1991, accessed October 8, 2011, http://www.sbaonline.sba.gov/idc/groups/public/documents/sba_homepage/serv_sbp _exit.pdf.
95. “Sample Succession Planning Policy,” accessed October 8, 2011, http://www.experienceworks.ca/pdf/successionpolicy.pdf
96. “Making a Difference: The PricewaterhouseCoopers Family Business Survey 2007/08,” PriceWaterhouseCoopers, November 2007, accessed October 8, 2011, http://www.pwc.com/en_TH/th/publications/assets/pwc_fbs_survey.pdf.
97. “Family-Run Businesses: Succession Planning in Family Businesses,” Business Link, accessed October 8, 2011, http://www.businesslink.gov.uk/bdotg/action/detail?type =RESOURCES&itemId=1074446767
98. “Avoid Feuds When Handing Down the Family Business,” 2010, AllBusiness.com, 2010, accessed October 8, 2011, http://www.allbusiness.com/buying-exiting-businesses/exiting-a-business/2975479-1.html.
99. “Components of a Good Business Succession Plan,” April 18, 2011, accessed October 8, 2011, http://www.entrepreneurshipsecret.com/components-of-a-good-business -succession-plan.
100. Susan Ward, “Six Business Succession Planning Tips,” About.com, 2011, accessed October 8, 2011, sbinfocanada.about.com/cs/buysellabiz/a/succession1_2.htm.
101. Susan Ward, “Six Business Succession Planning Tips,” About.com, 2011, accessed October 8, 2011, sbinfocanada.about.com/cs/buysellabiz/a/succession1_2.htm.
102. “Family Succession Plan First Then the Succession Plan for the Family’s Business,” Family Business Experts, 2011, accessed October 8, 2011, http://www.family-business-experts.com/family-succession-plan.html.
103. Karen E. Klein, “When the Third Generation Runs the Family Biz,” Bloomberg BusinessWeek, April 9, 2010, accessed October 8, 2011, http://www.BusinessWeek.com/smallbiz/content/apr2010/sb2010049_806426.htm.
104. George Ambler, “Constructive Conflict Is Essential for Creating Commitment to Decisions,” May 15, 2007, accessed October 8, 2011
105. Kimberly A. Eddleston, Robert F. Otondo, and Franz Willi Kellermanns, “Conflict, Participative Decision-Making, and Generational Ownership Dispersion: A Multilevel Analysis,” Journal of Small Business Management 46, no. 3 (2008): 456–84
106. Suzi Quixley, “Understanding Constructive & Destructive Conflict,” May 2008, accessed June 1, 2012, http://www.suziqconsulting.com.au/free_articles_files /CON%20-%20Constructive%20&%20Destructive%20-%20May08.pdf
107. “Managing Conflict in Family Businesses,” Business Link, 2010, accessed October 8, 2011, http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId= 1073792653.
108. Kimberly A. Eddleston, Robert F. Otondo, and Franz Willi Kellermanns, “Conflict, Participative Decision-Making, and Generational Ownership Dispersion: A Multilevel Analysis,” Journal of Small Business Management 46, no. 3 (2008): 456–84
109. Suzi Quixley, “Understanding Constructive & Destructive Conflict,” May 2008, accessed June 1, 2012, http://www.suziqconsulting.com.au/free_articles_files /CON%20-%20Constructive%20&%20Destructive%20-%20May08.pdf
110. Professor Michael Roberto from Harvard Business School, quoted in George Ambler, “Constructive Conflict Is Essential for Creating Commitment to Decisions,” May 15, 2007, accessed October 8, 2011
111. Nigel Finch, “Identifying and Addressing the Causes of Conflict in Family Business,” Working Paper Series: University of Sydney, May 2005, accessed October 8, 2011, papers.ssrn.com/sol3/papers.cfm?abstract_id=717262.
112. “Managing Conflict in Family Businesses,” Business Link, 2010, accessed October 8, 2011, http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId= 1073792653
113. Nigel Finch, “Identifying and Addressing the Causes of Conflict in Family Business,” Working Paper Series: University of Sydney, May 2005, accessed October 8, 2011, papers.ssrn.com/sol3/papers.cfm?abstract_id=717262
114. Kimberly A. Eddleston, Robert F. Otondo, and Franz Willi Kellermanns, “Conflict, Participative Decision-Making, and Generational Ownership Dispersion: A Multilevel Analysis,” Journal of Small Business Management 46, no. 3 (2008): 456–84.
115. “Making a Difference: The PricewaterhouseCoopers Family Business Survey 2007/08,” PriceWaterhouseCoopers, November 2007, accessed October 8, 2011, http://www.pwc.com/en_TH/th/publications/assets/pwc_fbs_survey.pdf
116. Kimberly A. Eddleston, Robert F. Otondo, and Franz Willi Kellermanns, “Conflict, Participative Decision-Making, and Generational Ownership Dispersion: A Multilevel Analysis,” Journal of Small Business Management 46, no. 3 (2008): 456–84.
117. Michael Harvey and Rodney E. Evans, “Family Business and Multiple Levels of Conflict,” Family Business Review 7, no. 4 (1994): 331–48, as cited in Kimberly A. Eddleston, Robert F. Otondo, and Franz Willi Kellermanns, “Conflict, Participative Decision-Making, and Generational Ownership Dispersion: A Multilevel Analysis,” Journal of Small Business Management 46, no. 3 (2008): 456–84.
118. Harry Levinson, “Conflicts That Plague Family Businesses,” Harvard Business Review 71 (1971): 90–98
119. “Common Sources of Dysfunctional Conflict in Family Businesses,” RJW Consulting, accessed October 8, 2011, http://www.rjweissconsulting.com/businessDevelopmentNewsDetail.asp?ID=2
120. Nigel Finch, “Identifying and Addressing the Causes of Conflict in Family Business,” Working Paper Series: University of Sydney, May 2005, accessed October 8, 2011, papers.ssrn.com/sol3/papers.cfm?abstract_id=717262.
121. Nigel Finch, “Identifying and Addressing the Causes of Conflict in Family Business,” Working Paper Series: University of Sydney, May 2005, accessed October 8, 2011, papers.ssrn.com/sol3/papers.cfm?abstract_id=717262
122. “Common Sources of Dysfunctional Conflict in Family Businesses,” RJW Consulting, accessed October 8, 2011, http://www.rjweissconsulting.com/businessDevelopmentNewsDetail.asp?ID=2
123. Peter S. Davis and Paula D. Harveston, “The Phenomenon of Substantive Conflict in the Family Firm: A Cross-Generational Study,” Journal of Small Business Management 39, no. 1 (2001): 14–30
124. “Common Sources of Dysfunctional Conflict in Family Businesses,” RJW Consulting, accessed October 8, 2011, http://www.rjweissconsulting.com/businessDevelopmentNewsDetail.asp?ID=2.
125. Wayne Rivers, “Top 15 Sources of Conflict in Family Businesses,” Family Business Institute, 2009, accessed October 8, 2011, http://www.familybusinessinstitute.com/index.php/volume-6-articles/top-15-sources-of-conflict-in-family-businesses.html.
126. “How Family Squabbling Affects Other Employees—and Customers,” National Federation of Independent Business, 2010, accessed October 8, 2011, http://www.nfib.com/business-resources/business-resources-item?cmsid=52150
127. “How Family Squabbling Affects Other Employees—and Customers,” National Federation of Independent Business, 2010, accessed October 8, 2011, http://www.nfib.com/business-resources/business-resources-item?cmsid=52150.
128. “How Family Squabbling Affects Other Employees—and Customers,” National Federation of Independent Business, 2010, accessed October 8, 2011, http://www.nfib.com/business-resources/business-resources-item?cmsid=52150
129. “How Family Squabbling Affects Other Employees—and Customers,” National Federation of Independent Business, 2010, accessed October 8, 2011, http://www.nfib.com/business-resources/business-resources-item?cmsid=52150.
130. “How Family Squabbling Affects Other Employees—and Customers,” National Federation of Independent Business, 2010, accessed October 8, 2011, http://www.nfib.com/business-resources/business-resources-item?cmsid=52150.
131. George Ambler, “Constructive Conflict Is Essential for Creating Commitment to Decisions,” May 15, 2007, accessed October 8, 2011
132. George Ambler, “Constructive Conflict Is Essential for Creating Commitment to Decisions,” May 15, 2007, accessed October 8, 2011.
133. “The Lobster Tale,” http://www.westbrooklobster.com/Wallingford/pages/wally_home.html (accessed on October 8, 2011)
134. interview with Michael Larivere, October 11, 2010. | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/01%3A_Foundations_of_Business/1.03%3A_Chapter_3-_Family_Businesses.txt |
Robert took every opportunity available to better understand his customers and provide them with value. One way his business does this is by developing a personal relationship with its customers. This may mean carefully looking at checks or credit cards, not for security reasons, but to identify customers by name. Robert points out that he always pays careful attention to what customers like and dislike; by doing so, they develop confidence in his suggestions. To foster this confidence, he and his family actively engage their customers in conversations. Customers, Robert, and the employees share stories, which is a key way to build better customer relationships. By listening to his customers, Robert can identify what they are looking for and assist him in knowing what new products he might offer.
In addition to this personalized level of service, the Cheshire Package Store also recognizes the importance of other factors. Robert talks about the importance of maintaining a well-lit store with spacious aisles, making it an inviting place in which to shop. He is careful about even minor details, such as assuring that there are open parking spaces near the entrance to his store. He recognizes that even walking short distances to or from the store might be a burden or deterrent for his customers. Robert’s store possesses a cutting-edge inventory software package designed specifically for liquor stores. It enables him to track inventory levels, which can provide estimates for future inventory levels of different products; however, he sees this as a guide only. As he puts it, “Your knowledge of your customers will be the key determinant for your success.”
Robert also strongly believes that the success of a small business depends on the owner being there. Stores have their own personality, in his view, and that personality is created by the owner. This personality imparted by the owner impacts all operational aspects of the business—“Your employees will pick up on what you expect, and they will know what your customers deserve.”
Defining the Customer’s Concept of Value
Learning Objectives
1. Define customer value.
2. Understand the five sources of perceived customer benefits.
3. Understand the three sources of perceived costs.
Look beneath the surface; let not the several qualities of neither the thing, nor its worth escape thee.
Marcus Aurelius Antoninus
In the previous chapter, Peter Drucker and W. Edward Deming placed the customer at the center of their definitions of the purpose of a business. They used the customer as being at the core of that purpose rather than focusing on financial measures such as profit, return on investment (ROI), or shareholders’ wealth. Drucker’s logic was that if a business did not create a sufficient number of customers, there never would be a profit with the business. Deming argued that delighting customers would become the basis for them to consistently return, and loyalty would ensure that the business would have a higher probability of surviving in the long term. The clearest way of doing that is by focusing on providing your customers with a clear sense of value. This emphasis on value will produce economic benefits. Gale Consulting explains the notion of value this way, “If customers don’t get good value from you, they will shop around to find a better deal.” [1]
A recent study put it this way, “These firms have been successful…by consistently creating superior customer value, and profiting handsomely from that customer value.”[2]
Strong evidence indicates that this focus on making the customer central to defining the business translates into economic success. It has been estimated that the cost of gaining a new customer over retaining a current customer is a multiple of five. The costs of regaining a dissatisfied customer over the cost of retaining a customer are ten times as much.[3] So a key question for any business then becomes, “How does one then go about making the customer the center of one’s business?”
What Is Value?
It is essential to recognize that value is not just price. Value is a much richer concept. Fundamentally, the notion of customer value is fairly basic and relatively simple to understand; however, implementing this concept can prove to be tremendously challenging. It is a challenge because customer value is highly dynamic and can change for a variety of reasons, including the following: the business may change elements that are important to the customer value calculation, customers’ preferences and perceptions may change over time, and competitors may change what they offer to customers. One author states that the challenge is to “understand the ever changing customer needs and innovate to gratify those needs.” [4]
The simple version of the concept of customer value is that individuals evaluate the perceived benefits of some product or service and then compare that with their perceived cost of acquiring that product or service. If the benefits outweigh the cost, the product or the service is then seen as attractive (see Figure 4.1 “Perceived Cost versus Perceived Benefits”). This concept is often expressed as a straightforward equation that measures the difference between these two values:
customer value = perceived benefits − perceived cost.
Some researchers express this idea of customer value not as a difference but as a ratio of these two factors. [5] Either way, it needs to be understood that customers do not evaluate these factors in isolation. They evaluate them with respect to their expectations and the competition.
Firms that provide greater customer value relative to their competitors should expect to see higher revenues and superior returns. Robert Buzzell and Bradley Gale, reporting on one finding in the Profit Impact through Marketing Strategy study, a massive research project involving 2,800 businesses, showed that firms with superior customer value outperform their competitors on ROI and market share gains.[6]
Given this importance, it is critical to understand what makes up the perceived benefits and the perceived costs in the eyes of the consumer. These critical issues have produced a considerable body of research. Some of the major themes in customer value are evolving, and there is no universal consensus or agreement on all aspects of defining these two components. First, there are approaches that provide richly detailed and academically flavored definitions; others provide simpler and more practical definitions. These latter definitions tend to be ones that are closer to the aforementioned equation approach, where customers evaluate the benefits they gain from the purchase versus what it costs them to purchase.
However, one is still left with the issue of identifying the specific components of these benefits and costs. In looking at the benefits portion of the value equation, most researchers find that customer needs define the benefits component of value. But there still is no consensus as to what specific needs should be considered. Park, Jaworski, and McGinnis (1986) specified three broad types of needs of consumers that determine or impact value provided five types of value[7][8]; as did Woodall (2003), although he did not identify the same five values.
To add to the confusion, Heard (1993–94)[10]identified three factors, while Ulaga (2003)[11] specified eight categories of value; and Gentile, Spiller, and Noci (2007) mentioned six components of value.[12] Smith and Colgate (2007) attempted to place the discussion of customer value in a pragmatic context that might aid practitioners. They identified four types of values and five sources of value. Their purpose was to provide “a foundation for measuring or assessing value creation strategies.”[13] In some of these works, the components or dimensions of value singularly consider the benefits side of the equation, while others incorporate cost dimensions as part of value.
From the standpoint of small businesses, what sense can be made of all this confusion? First, the components of the benefits portion of customer value need to be identified in a way that has significance for small businesses. Second, cost components also need to be identified. Seth, Newman, and Gross’s five types of value provide a solid basis for considering perceived benefits (see Figure 4.2 “Five Types of Value”). Before specifying the five types of value, it is critical to emphasize that a business should not intend to compete on only one type of value. It must consider the mix of values that it will offer its customers. (In discussing these five values, it is important to provide the reader with examples. Most of our examples will relate to small business, but in some cases, good examples will have to be drawn from larger firms because they are better known.)
Figure 4.2 Five Types of Value
The five types of value are as follows:
1. Functional value relates to the product’s or the service’s ability to perform its utilitarian purpose. Woodruff (1997) identified that functional value can have several dimensions.[14] One dimension would be performance related. This relates to characteristics that would have some degree of measurability, such as appropriate performance, speed of service, quality, or reliability. A car may be judged on its miles per gallon or the time to go from zero to sixty miles per hour. These concepts can also be seen when evaluating a garage that is performing auto repairs. Customers have an expectation that the repairs will be done correctly, that the car will not have to be brought back for additional work on the same problem, and that the repairs will be done in a reasonable amount of time. Another dimension of functional value might consider the extent to which the product or the service has the correct features or characteristics. In considering the purchase of a laptop computer, customers may compare different models on the basis of weight, battery lifetime, or speed. The notion of features or characteristics can be, at times, quite broad. Features might include aesthetics or an innovation component. Some restaurants will be judged on their ambiance; others may be judged on the creativity of their cuisine. Another dimension of functional value may be related to the final outcomes produced by a business. A hospital might be evaluated by its number of successes in carrying out a particular surgical procedure.
2. Social value involves a sense of relationship with other groups by using images or symbols. This may appear to be a rather abstract concept, but it is used by many businesses in many ways. Boutique clothing stores often try to convey a chic or trendy environment so that customers feel that they are on the cutting edge of fashion. Rolex watches try to convey the sense that their owners are members of an economic elite. Restaurants may alter their menus and decorations to reflect a particular ethnic cuisine. Some businesses may wish to be identified with particular causes. Local businesses may support local Little League teams. They may promote fundraising for a particular charity that they support. A business, such as Ben & Jerry’s Ice Cream, may emphasize a commitment to the environment or sustainability.
3. Emotional value is derived from the ability to evoke an emotional or an affective response. This can cover a wide range of emotional responses. Insurance companies and security alarm businesses are able to tap into both fear and the need for security to provide value. Some theme parks emphasize the excitement that customers will experience with a range of rides. A restaurant may seek to create a romantic environment for diners. This might entail the presence of music or candlelight. Some businesses try to remind customers of a particular emotional state. Food companies and restaurants may wish to stimulate childhood memories or the comfort associated with a home-cooked meal. Häagen-Dazs is currently producing a line of all-natural ice cream with a limited number of natural flavors. It is designed to appeal to consumers’ sense of nostalgia.[15]
4. Epistemic value is generated by a sense of novelty or simple fun, which can be derived by inducing curiosity or a desire to learn more about a product or a service. Stew Leonard’s began in the 1920s as a small dairy in Norwalk, Connecticut. Today, it is a \$300 million per year enterprise of consisting of four grocery stores. It has been discussed in major management textbooks. These accomplishments are due to the desire to turn grocery shopping into a “fun” experience. Stew Leonard’s uses a petting zoo, animatronic figures, and costumed characters to create a unique shopping environment. They use a different form of layout from other grocery stores. Customers are required to follow a fixed path that takes them through the entire store. Thus customers are exposed to all items in the store. In 1992, they were awarded a Guinness Book world record for generating more sales per square foot than any food store in the United States. Another example of a business that employs epistemic value is Rosetta Stone, a company that sells language-learning software. Rosetta Stone emphasizes the ease of learning and the importance of acquiring fluency in another language through its innovative approach.
5. Conditional value is derived from a particular context or a sociocultural setting. Many businesses learn to draw on shared traditions, such as holidays. For the vast majority of Americans, Thanksgiving means eating turkey with the family. Supermarkets and grocery stores recognize this and increase their inventory of turkeys and other foods associated with this period of the year. Holidays become a basis for many retail businesses to tap into conditional value.
Another way businesses may think about conditional value is to introduce a focus on emphasizing or creating a sociocultural context. Business may want to introduce a “tribal” element into their customer base, by using efforts that cause customers to view themselves as a member of a special group. Apple Computer does this quite well. Many owners of Apple computers view themselves as a special breed set apart from other computer users. This sense of special identity helps Apple in the sale of its other electronic consumer products. They reinforce this notion in the design and setup of Apple stores. Harley-Davidson does not just sell motorcycles; it sells a lifestyle. Harley-Davidson also has a lucrative side business selling accessories and apparel. The company supports owner groups around the world. All of this reinforces, among its customers, a sense of shared identity.
It should be readily seen that these five sources of value benefits are not rigorously distinct from each other. A notion of aesthetics might be applied, in different ways, across several of these value benefits. It also should be obvious that no business should plan to compete on the basis of only one source of value benefits. Likewise, it may be impossible for many businesses, particularly start-ups, to attempt to use all five dimensions. Each business, after identifying its customer base, must determine its own mix of these value benefits.
As previously pointed out, the notion of perceived customer value has two components—perceived value benefits and perceived value costs. When examining the cost component, customers need to recognize that it is more than just the cost of purchasing a product or a service. Perceived cost should also be seen having multiple dimensions (see Figure 4.3 “Components of Customer Value”).
Figure 4.3 Components of Customer Value
Perceived costs can be seen as being monetary, time, and psychic. The monetary component of perceived costs should, in turn, be broken down into its constituent elements. Obviously, the first component is the purchase price of the product or the service. Many would mistakenly think that this is the only element to be considered as part of the cost component. They fail to consider several other cost components that are quite often of equal—if not greater—importance to customers. Many customers will consider the operating cost of a product or a service. A television cable company may promote an introductory offer with a very low price for the cable box and its installation. Most customers will consider the monthly fees for cable service rather than just looking at the installation cost. They often use service costs when evaluating the value proposition. Customers have discovered that there are high costs associated with servicing a product. If there are service costs, particularly if they are hidden costs, then customers will find significantly less value from that product or service. Two other costs also need to be considered. Switching cost is associated with moving from one provider to another. In some parts of the country, the cost of heating one’s home with propane gas might be significantly less than using home heating oil on an annualized basis. However, this switch from heating oil to propane would require the homeowner to install a new type of furnace. That cost might deter the homeowner from moving to the cheaper form of energy. Opportunity cost involves selecting among alternative purchases. A customer may be looking at an expensive piece of jewelry that he wishes to buy for his wife. If he buys the jewelry, he may have to forgo the purchase of a new television. The jewelry would then be the opportunity cost for the television; likewise, the television would be the opportunity cost for the piece of jewelry. When considering the cost component of the value equation, business people should view each cost as part of an integrated package to be set forth before customers. More and more car dealerships are trying to win customers by not only lowering the sticker price but also offering low-cost or free maintenance during a significant portion of the lifetime of the vehicle.
These monetary components are what we most often think of when we discuss the term cost, and, of course, they will influence the decision of customers; however, the time component is also vital to the decision-making process. Customers may have to expend time acquiring information about the nature of the product or the service or make comparisons between competing products and services. Time must be expended to acquire the product or the service. This notion of time would be associated with learning where the product or the service could be purchased. It would include time spent traveling to the location where the item would be purchased or the time it takes to have the item delivered to the customer. One also must consider the time that might be required to learn how to use the product or the service. Any product or service with a steep learning curve might deter customers from purchasing it. Firms can provide additional value by reducing the time component. They could simplify access to the product or the service. They may offer a wide number of locations. Easy-to-understand instructions or simplicity in operations may reduce the amount of time that is required to learn how to properly use the product or the service.
The psychic component of cost can be associated with those factors that might induce stress on the customer. There can be stress associated with finding or evaluating products and services. In addition, products or services that are difficult to use or require a long time to learn how to use properly can cause stress on customers. Campbell’s soup introduced a meal product called Souper Combos, which consisted of a sandwich and a cup of soup. At face value, one would think that this would be a successful product. Unfortunately, there were problems with the demands that this product placed on the customer in terms of preparing the meal. The frozen soup took twice as long to microwave as anticipated, and the consumer had to repeatedly insert and remove both the soup and the sandwich from the microwave.[17]
In summary, business owners need to constantly consider how they can enhance the benefits component while reducing the cost components of the value equation. Table 4.1 “Components of Perceived Benefit and Perceived Cost” summarizes the subcomponents of perceived value, the types of firms that emphasize those components, and the activities that might be necessary to either enhance benefits or reduce costs.
Table 4.1 Components of Perceived Benefit and Perceived Cost
Component Aspects Activities to Deliver
Components of Perceived Benefit
Functional
• Measurable quality
• Performance
• Reliability
• Support network
• Quality assurance in product and services
• Superior product and process design
• Selection of correct attributes
• Ability to improve product and operations
• Management of value chain
Social
• Builds identification with social, ethnic, or class group
• Emphasize lifestyle
• Development of interaction among people
• Build bonds within groups
• Market research correctly identifies customer base(s)
• Ability to build social community among customers
Emotional
• Assist in making one feel good about themselves
• Attachment to product or service
• Produces a change in how others see the user
• Trustworthiness
• Profound customer experience
• Aesthetics
• Market research understands psychological dimensions of customer base(s)
• Marketing content emphasizes desired psychological dimensions
• Reliability between marketing message and delivery
Epistemic
• Novelty
• Fun
• Evoke interest in product or service
• Interest in learning
• Produces a willing suspension of disbelief
• Creative personnel
• Creative product or process development
• Commitment to innovation
• Willingness to experiment
Conditional
• Produces meaning in a specific context
• Tied to particular events
• Tied to holidays
• Demonstrates social responsibility
• Flexibility (can alter physical facilities or marketing message depending on context)
• Management commitment to responsible action
Components of Perceived Cost
Monetary
• Reduce purchase price
• Reduce operating costs
• Reduce maintenance costs
• Reduce opportunity costs
• Superior design
• Operational efficiency
• Cost containment
• Quality control and assurance
• Easy acquisition
Time
• Reduce time to search for product or service
• Reduce time to purchase
• Reduced learning curve
• Broad distribution channels
• Web-based purchasing option
• Web-based information
• Superior design
Psychic
• Simplified use
• “Comfortable” feeling with regard to product or service use
• Superior design
• Ability to write clear instructions
Video Clip 4.1- Customer Value
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
What creates a customer experience of value?
Video Clip 4.2- Creating Customer Value
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Creating value is the essence of a start-up. This video reviews the product and value created by a watch with no hands.
Video Clip 4.3- Simple Rules: Three Logics of Value Creation
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Three core logics of the value proposition.
Video Clip 4.4- Articulating Your Value Proposition
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
A video on how to better articulate your value proposition. This is informative but very long (about one hour).
Different Customers—Different Definitions
It is a cliché to say that people are different; nonetheless, it is true to a certain extent. If all people were totally distinct individuals, the notion of customer value might be an interesting intellectual exercise, but it would be absolutely useless from the standpoint of business because it would be impossible to identify a very unique definition of value for every individual. Fortunately, although people are individuals, they often operate as members of groups that share similar traits, insights, and interests. This notion of customers being members of some type of group becomes the basis of the concept known as market segmentation. It involves recognizing that the market at large is not homogeneous. This involves dividing the market into several portions that are different from each other. [18] It simply involves recognizing that the market at large is not homogeneous. There can be several dimensions along which a market may be segmented: geography, demographics, psychographics, or purchasing behavior. Geographic segmentation can be done by global or national region, population size or density, or even climate. Demographic segmentation divides a market on factors such as gender, age, income, ethnicity, or occupation. Psychographic segmentation is carried out on dimensions that reflect differences in personality, opinions, values, or lifestyle. Purchasing behavior can be another basis for segmentation. Differences among customers are determined based on a customer’s usage of the product or the service, the frequency of purchases, the average value of purchases, and the status as a customer—major purchaser, first-time user, or infrequent customer. In the business-to-business (B2B) environment, one might want to segment customers on the basis of the type of company.
Market segmentation recognizes that not all people of the same segment are identical; it facilitates a better understanding of the needs and wants of particular customer groups. This comprehension should enable a business to provide greater customer value. There are several reasons why a small business should be concerned with market segmentation. The main reason centers on providing better customer value. This may be the main source of competitive advantage for a small business over its larger rivals. Segmentation may also indicate that a small business should focus on particular subsets of customers. Not all customers are equally attractive. Some customers may be the source of most of the profits of a business, while others may represent a net loss to a business. The requirements for providing value to a first-time buyer may differ significantly from the value notions for long time, valued customer. A failure to recognize differences among customers may lead to significant waste of resources and might even be a threat to the very existence of a firm.
Video Clip 4.5- Tom Peters: The Biggest Underserved Markets
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Tom Peters, a self-described “professional loudmouth” who has been compared to Ralph Waldo Emerson, Walt Whitman, Henry David Thoreau, and H. L. (Henry Louis) Mencken, declares war on the worthless rules and absurd organizational barriers that stand in the way of creativity and success. In a totally outrageous, in-your-face presentation, Peters reveals the following: a re-imagining of American business; two big markets—underserved and worth trillions; the top qualities of leadership excellence; and why passion, talent, and action must rule business today.
Key Takeaways
• Essential to the success of any business is the need to correctly identify customer value.
• Customer value can be seen as the difference between a customer’s perceived benefits and the perceived costs.
• Perceived benefits can be derived from five value sources: functional, social, emotional, epistemic, and conditional.
• Perceived costs can be seen as having three elements: monetary, time, and psychic.
• To better provide value to customers, it may be necessary to segment the market.
• Market segmentation can be done on the basis of demographics, psychographics, or purchasing behavior.
Exercises
Frank’s All-American BarBeQue
Robert Rainsford is a twenty-eight-year-old facing a major turning point in his life. He has found himself unemployed for the first time since he was fifteen years old. Robert holds a BS degree in marketing from the University of Rhode Island. After graduation, a firm that specialized in developing web presences for other companies hired him. He worked for that firm for the last seven years in New York City. Robert rose rapidly through the company’s ranks, eventually becoming one of the firm’s vice presidents. Unfortunately, during the last recession, the firm suffered significant losses and engaged in extensive downsizing, so Robert lost his job. He spent months looking for a comparable position, yet even with an excellent résumé, nothing seemed to be on the horizon. Not wanting to exhaust his savings and finding it impossible to maintain a low-cost residence in New York City, he returned to his hometown in Fairfield, Connecticut, a suburban community not too far from the New York state border.
He found a small apartment near his parents. As a stopgap measure, he went back to work with his father, who is the owner of a restaurant—Frank’s All-American BarBeQue. His father, Frank, started the restaurant in 1972. It is a midsize restaurant—with about eighty seats—that Frank has built up into a relatively successful and locally well-known enterprise. The restaurant has been at its present location since the early 1980s. It shares a parking lot with several other stores in the small mall where it is located. The restaurant places an emphasis on featuring the food and had a highly simplified décor, where tables are covered with butcher paper rather than linen tablecloths. Robert’s father has won many awards at regional and national barbecue cook-offs, which is unusual for a business in New England. He has won for both his barbecue food and his sauces. The restaurant has been repeatedly written up in the local and New York papers for the quality of its food and the four special Frank’s All-American BarBeQue sauces. The four sauces correspond to America’s four styles of barbecue—Texan, Memphis, Kansas City, and Carolina. In the last few years, Frank had sold small lots of these sauces in the local supermarket.
As a teenager, Robert, along with his older sister Susan, worked in his father’s restaurant. During summer vacations while attending college, he continued to work in the restaurant. Robert had never anticipated working full-time in the family business, even though he knew his father had hoped that he would do so. By the time he returned to his hometown, his father had accepted that neither Robert nor Susan would be interested in taking over the family business. In fact, Frank had started to think about selling the business and retiring. However, Robert concluded that his situation called for what he saw as desperate measures.
Initially, Robert thought his employment at his father’s business was a temporary measure while he continued his job search. Interestingly, within the first few weeks he returned to the business, he felt that he could bring his expertise in marketing—particularly his web marketing focus—to his father’s business. Robert became very enthusiastic about the possibility of fully participating in the family business. He thought about either expanding the size of the restaurant, adding a takeout option, or creating other locations outside his hometown. Robert looked at the possibility of securing a much larger site within his hometown to expand the restaurant’s operations. He began to scout surrounding communities for possible locations. He also began to map out a program to effectively use the web to market Frank’s All-American BarBeQue sauce and, in fact, to build it up to a whole new level of operational sophistication in marketing.
Robert recognized that the restaurant was as much of a child to his father as he and his sister were. He knew that if he were to approach his father with his ideas concerning expanding Frank’s All-American BarBeQue, he would have to think very carefully about the options and proposals he would present to his father. Frank’s All-American BarBeQue was one of many restaurants in Fairfield, but it is the only one that specializes in barbecue. Given the turnover in restaurants, it was amazing that Frank had been able to not only survive but also prosper. Robert recognized that his father was obviously doing something right. As a teenager, he would always hear his father saying the restaurant’s success was based on “giving people great simple food at a reasonable price in a place where they feel comfortable.” He wanted to make sure that the proposals he would present to his father would not destroy Frank’s recipe for success.
1. Discuss how Robert should explicitly consider the customer value currently offered by Frank’s All-American BarBeQue. In your discussion, comment on the five value benefits and the perceived costs.
2. Robert has several possible options for expanding his father’s business—find a larger location in Fairfield, add a takeout option, open more restaurants in surrounding communities, incorporate web marketing concepts, and expand the sales of sauces. Review each in terms of value benefits.
3. What would be the costs associated with those options?
Knowing Your Customers
Learning Objectives
1. Understand that in order to provide customer value, firms must be able to listen to the voice of the customer.
2. Comprehend that businesses must attempt to identify those customers’ needs that are not being met by competitors.
3. Understand that businesses should segment their customers to better meet their needs.
4. Understand that businesses should consider the lifetime value of their various customer segments.
5. Understand that although some businesses can create products and services based on their intuitive insights, others need to conduct careful analyses.
6. Comprehend that new product or service development requires that organizations support creativity and innovation.
The perceived value proposition offers a significant challenge to any business. It requires that a business have a fairly complete understanding of the customer’s perception of benefits and costs. Although market segmentation may help a business better understand some segments of the market, the challenge is still getting to understand the customer. In many cases, customers themselves may have difficulty in clearly understanding what they perceive as the benefits and costs of any offer. How then is a business, particularly a small business, to identify this vital requirement? The simple answer is that a business must be open to every opportunity to listen to the voice of the customer (VOC). This may involve actively talking to your customers on a one-to-one basis, as illustrated by Robert Brown, the small business owner highlighted at the beginning of this chapter. It may involve other methods of soliciting feedback from your customers, such as satisfaction surveys or using the company’s website. Businesses may engage in market research projects to better understand their customers or evaluate proposed new products and services. Regardless of what mechanism is used, it should serve one purpose—to better understand the needs and wants of your customers.
Video Clip 4.6- Robin Lawton—Voice of the Customer—What Do Customers Value?
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
International Management Technologies introduces Robin Lawton on the topic of “What Do Customers Value?”
Video Clip 4.7- Robin Lawton—Voice of the Customer—Basis for Satisfaction Keynote
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
The customer-centered organization begins the transformation process by understanding how to uncover and understand the VOC.
Research
Good research in the area of customer value simply means that one must stop talking to the customer—talking through displays, advertising, and/or a website. It means that one is always open to listening carefully to the VOC. Active listening in the service of better identifying customer value means that one is always open to the question of how your business can better solve the problems of particular customers.
If businesses are to become better listeners, what should they be listening for? What types of questions should they be asking their customers? Businesses should address the following questions when they attempt to make customer value the focus of their existence:
• What needs of our customers are we currently meeting?
• What needs of our customers are we currently failing to meet?
• Do our customers understand their own needs and are they aware of them?
• How are we going to identify those unmet customer needs?
• How are we going to listen to the VOC?
• How are we going to let the customer talk to us?
• What is the current value proposition that is desired by customers?
• How is the value proposition different for different customers?
• How—exactly—is our value proposition different from our competitors?
• Do I know why customers have left our business for our competitors?
Who Your Customer Is—and Is Not
At the beginning of this chapter, it was argued that your central focus must be the customer. One critical way that this might be achieved is by providing a customer with superior value. However, creating this value must be done in a way that assures that the business makes money. One way of doing this is by identifying and selecting those customers who will be profitable. Some have put forth the concept of customer lifetime value, a measure of the revenue generated by a customer, the cost generated for that particular customer, and the projected retention rate of that customer over his or her lifetime. [19],[20]
This concept is popular enough that there are lifetime value calculator templates available on the web. The Harvard Business School created the calculator used in Exercise 2.1. It looks at the cost of acquiring a customer and then computes the net present value. It recognizes the time value of money. of the customer during his or her lifetime. Net present value discounts the value of future cash flows. It recognizes the time value of money. You can use one of two models: a simple model that examines a single product or a more complex model with additional variables. One of the great benefits in conducting customer lifetime value analysis is combining it with the notion of market segmentation. The use of market segmentation allows for recognizing that certain classes of customers may produce significantly different profits during their lifetimes. Not all customers are the same.
Let us look at a simple case of segmentation based on behavioral factors. Some customers make more frequent purchases; these loyal customers may generate a disproportionate contribution of a firm’s overall profit. It has been estimated that only 15 percent of American customers have loyalty to a single retailer, yet these customers generate between 55 percent and 70 percent of retail sales.Likewise, a lifetime-based economic analysis of different customer segments may show that certain groups of customers actually cost more than the revenues that they generate.
Having segmented your customers, you will probably find that some require more handholding during and after the sale. Some customer groups may need you to “tailor” your product or service to their needs.[22] As previously mentioned, market segmentation can be done along several dimensions. Today, some firms use data mining to determine the basis of segmentation, but that often requires extensive databases, software, and statisticians. One simple way to segment your customers is the customer value matrix that is well suited for small retail and service businesses. It uses just three variables: recency, frequency, and monetary value. Its data requirements are basic. It needs customer identification, the date of purchase, and the total amount of purchase. This enables one to easily calculate the average purchase amount of each customer. From this, you can create programs that reach out to particular segments.[23]
Video Clip 4.8- Customer Lifetime Value
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Jack Daly presents the “client for life” concept, featuring Continuity Programs BCL programs of customer loyalty outsourced service.
Video Clip 4.9- Lifetime Customer Value
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Patrick McTigue explains how critical the lifetime value of a customer is to your business. He covers some tips to integrate superb customer service into your business model.
What Your Gut Tells You
The role of market research was already discussed in this chapter. For many small businesses, particularly very small businesses, formal market research may pose a problem. In many small businesses, there may be a conflict between decision making made on a professional basis and decision making made on an instinctual basis.[24] Some small business owners will always decide based on a gut instinct. We can point to many instances in which gut instinct concerning the possible success in product paid off, whereas a formal market research evaluation might consider the product to be a nonstarter.
In 1975, California salesman Gary Dahl came up with the idea of the ideal pet—a pet that would require minimal care and cost to maintain. He developed the idea of the pet rock. This unlikely concept became a fad and a great success for Dahl. Ken Hakuta, also known as Dr. Fad, developed a toy known as the Wallwalker in 1983. It sold over 240 million units. [25] These and other fad products, such as the Cabbage Patch dolls and Rubik’s Cube, are so peculiar that one would be hard pressed to think of any marketing research that would have indicated that they would be viable, let alone major successes.
Sometimes it is an issue of having a product idea and knowing where the correct market for the product will be. Jill Litwin created Peas a Pie Pizza, which is a natural food pizza pie with vegetables baked in the crust. She knew that the best place to market her unique product would be in the San Francisco area with its appreciation of organic foods.[26]
This notion of going with one’s gut instinct is not limited to fad products. Think of the birth of Apple Computer. The objective situation was dealing with a company whose two major executives were college dropouts. The business was operating out of the garage of the mother of one of these two executives. They were producing a product that up to that point had only a limited number of hobbyists as a market. None of this would add up to very attractive prospect for investment. You could easily envision a venture capitalist considering a possible investment asking for a market research study that would identify the target market(s) for its computers. None existed at the company’s birth. Even today, there is a strong indication that Apple does not rely heavily on formal marketing research. As Steve Jobs put it:[27]
It’s not about pop culture, it’s not about fooling people, and it’s not about convincing people that they want something they don’t. We figure out what we want. And I think we’re pretty good at having the right discipline to think through whether a lot of other people are going to want it, too. That’s what we get paid to do. So you can’t go out and ask people, you know, what’s the next big [thing.] There is a great quote by Henry Ford, right? He said, “If I had asked my customers what they wanted, they would’ve told me ‘A faster horse.’
The Voice of the Customer—QFD
Quality function deployment (QFD) is an approach that is meant to take the VOC concept seriously and uses it to help design new products and services or improve existing ones. It is an approach that was initially developed in Japan for manufacturing applications. It seeks “to transform user demands into design quality, to deploy the functions forming quality, and to deploy methods for achieving the design quality into subsystems and component parts, and ultimately to specific elements.”[28] To put it more clearly, QFD takes the desires of consumers and explores how well the individual activities of the business are meeting those desires. It also considers how company activities interact with each other and how well the company is meeting those customer desires with respect to the competition. It achieves all these ends through the means of a schematic; see Figure 4.4 “House of Quality”, which is known as the house of quality. The schematic provides the backbone for the entire QFD process. A comprehensive design process may use several houses of quality, moving from the first house, which concentrates on the initial specification of customer desires, all the way down to developing a house that focuses on the specification for parts or processes. Any house is composed of several components:
• Customer requirements (the whats). Here you identify the elements desired by customers; this section also contains the relative importance of these needs as identified by customers.
• Engineering characteristics (the hows). This is the means by which an organization seeks to meet customer needs.
• Relationship matrix. This illustrates the correlations among customer requirements and engineering characteristics. The degree of the correlation may be represented by different symbols.
• “Roof” of the house. This section illustrates the correlations among the engineering characteristics and reveals synergies that might exist among the engineering characteristics.
• Competitive assessment matrix. This is used to evaluate the position of a business with respect to its competition.
• “Basement.” This section is used for assessing the engineering characteristics or setting target values. The “basement” enables participants to instantly see the relative benefits of the activities undertaken by a company in meeting consumer desires by multiplying the values in each cell by the weight of the “why” and then adding the values together.
Figure 4.4 House of Quality
Although it might initially appear to be complex, QFD provides many benefits, including the following: (1) reduces time and effort during the design phase, (2) reduces alterations in design, (3) reduces the entire development time, (4) reduces the probability of inept design, (5) assists in team development, and (6) helps achieve common consensus.[29]
Unfortunately, QFD is most often associated with manufacturing. Few realize that it has found wide acceptance in many other areas—software development, services, education, amusement parks, restaurants, and food services. [30] Further, company size should not be seen as a limitation to its possible application. The QFD approach, in a simplified form, can be easily and successfully used by any business regardless of its size [31]. Its visual nature makes it extremely easy to comprehend, and it can convey to all members of the business the relative importance of the elements and what they do to help meet customers’ expectations. Figure 4.5 “Simplified House of Quality for a Restaurant” illustrates this by providing a simplified house of quality chart for a restaurant.
Video Clip 4.10- Quality Function Deployment Tutorial
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
This gives a brief overview of QFD.
QFD Analysis and Excel
Some companies provide Excel-based software that can assist in conducting a QFD analysis. This shows a template in the QI Macros software to help structure your thinking, making sure nothing is left out.[32]
How to Become a Better Listener
Although some succeed by listening to their instincts—their inner voices—it is highly advisable to all businesses to be proactive in trying to listen to the VOC. Listening to the customer is the domain of market research. However, it should not be surprising that many small businesses have severe resource constraints that make it difficult for them to use complex and sophisticated marketing and market research approaches. [33] To some extent, this is changing with the introduction of powerful, yet relatively low cost, web-based tools and social media. These will be discussed in greater detail in Section 2.4.2 “Digital Technology and E-Environment Implications” of this chapter. Another restriction that a small business may face in the area of marketing is that the owner’s marketing skills and knowledge may not be very extensive. The owners of such firms may opt for several types of solutions. They may try to mimic the marketing techniques employed by larger organizations, drawing on what was just mentioned. They may opt for sophisticated but easy to use analytical tools, or they may just simply take marketing tools and techniques and apply them to the small business environment.[34]
The most basic and obvious way to listen to customers is by talking to them. All businesses should support programs in which employees talk to customers and then record what they have to say about the product or the service. It is important to centralize these observations.
Other ways of listening to customers are through comment cards and paper and online surveys. These approaches have their strengths and limitations (see Note 2.31 “Video Clip 2.11”). Regardless of these limitations, they do provide an insight into your customers. Another way one can gather information about customers is through loyalty programs. Loyalty programs are used by 81 percent of US households.[35] Social media options—see Section 2.4.2 “Digital Technology and E-Environment Implications”—offer a tremendous opportunity to not only listen to your customer but also engage in an active dialog that can build a sustainable relationship with customers.
Video Clip 4.11- Listen to Your Customers and Express How Much You Care
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
This video details how easy and simple it is to show that you listen to your customers and care about them.
Video Clip 4.12- Ask, Listen, and Retain Video #4: Listening and Analyzing What Your Customers Say?
https://youtube.com/watch?v=_fIGefvkT_0
This is the fourth in a series of videos on listening to customers. This video covers how to analyze any disengaged or disgruntled customers. Once a customer is identified, our process ensures that action is taken to reengage the customer by dealing with the concerns at hand. But most importantly, the process encourages the development of a relationship between the customer and branch level management.
Website
Cisco Website for Innovation; A web forum for small businesses to share information [36]
Key Takeaways
• Businesses must become proactive in attempting to identify the value proposition of their customers. They must know how to listen to the VOC.
• Businesses must make every effort to identify the unmet needs of their customers.
• Businesses should recognize that customer segmentation would enable them to better provide customer value to their various customers.
• Businesses should think in terms of computing the customer lifetime value within different customer segments.
• Intuition can play an important role in the development of new products and services.
• Tools and techniques such as QFD assist in the design of products and services so that a business may be better able to meet customer expectations.
• Innovation can play a key role in creating competitive advantage for small businesses.
• Innovation does not require a huge investment; it can be done by small firms by promoting creativity throughout the organization.
• Small businesses must be open to new social and consumer trends. Readily available technology can help them in identifying such trends.
Exercises
1. The Harvard Business School provides an online customer lifetime value calculator at hbsp.harvard.edu/multimedia/flashtools/cltv/index.html. You provide some key values, and it computes the net present value of customer purchases. Go to the site and use the following data. What impact does changing the customer retention have on the value of the customer?
Average spent per purchase \$250.00
Average number of purchases per period 4
Direct marketing cost per period per year \$30
Average gross margin 20%
Average retention rate 25%, 35%, 50%, 70%, 80%, and 90%
Annual discount rate 10%
2. Imagine you are planning to open a boutique clothing store in the downtown section of a major city in the United States. You are interested in using a QFD chart to help you design the store. Identify the customer requirements (whats) in the engineering characteristics (hows). You need not to conduct a full-blown QFD analysis but at least show the degree of relationship between customer requirements and engineering characteristics.
3. You are the owner of a children’s clothing store in a prosperous suburban community. What methods and techniques might you use to become more adept at listening to the VOC? Outline specific programs that go beyond just talking to your customer that might enable you to better understand their notion of value.
Sources of Business Ideas
Learning Objectives
1. Understand that creativity and innovation are critical for small businesses.
2. Realize that innovation need not be limited to the creation of new products and services. It may involve seeing new uses for a product, new ways of packaging a product, or new ways of marketing a product.
3. Understand that creativity and innovation must be nurtured in any organization and that there are several areas small businesses must learn to avoid in order to promote creativity.
4. Realize that small businesses should be aware of social and consumer trends, which has been made easier because of the existence of online data sources.
Small businesses have always been a driver of new products and services. Many products and inventions that we might commonly associate with large businesses were originally created by small businesses, including air-conditioners, Bakelite, the FM radio, the gyrocompass, the high resolution computed axial tomography scanner, the outboard engine, the pacemaker, the personal computer, frozen food, the safety razor, soft contact lenses, and the zipper.[37] This creativity and innovative capability probably stems from the fact that smaller businesses, which may lack extensive financial resources, bureaucratic restraints, or physical resources, may find a competitive edge by providing customers value by offering new products and services. It is therefore important to consider how small businesses can foster a commitment to creativity and innovation.
Creativity and Innovation
One way smaller firms may compete with their larger rivals is by being better at the process of innovation, which involves creating something that is new and different. It need not be limited to the creation of new products and services. Innovation can involve new ways in which a product or a service might be used. It can involve new ways of packaging a product or a service. Innovation can be associated with identifying new customers or new ways to reach customers. To put it simply, innovation centers on finding new ways to provide customer value.
Although some would argue that there is a difference between creativity and innovation, one would be hard pressed to argue that creativity is not required to produce innovative means of constructing customer value. An entire chapter, even an entire book, could be devoted to fostering creativity in a small business. This text will take a different track; it will look at those factors that might inhibit or kill creativity. Alexander Hiam (1998) identified nine factors that can impede the creative mind-set in organizations: [38]
1. Failure to ask questions. Small-business owners and their employees often fail to ask the required why-type questions.
2. Failure to record ideas. It does not help if individuals in an organization are creative and produce a large number of ideas but other members of the organization cannot evaluate these ideas. Therefore, it is important for you to record and share ideas.
3. Failure to revisit ideas. One of the benefits of recording ideas is that if they are not immediately implemented, they may become viable at some point in the future.
4. Failure to express ideas. Sometimes individuals are unwilling to express new ideas for fear of criticism. In some organizations, we are too willing to critique an idea before it is allowed to fully develop.
5. Failure to think in new ways. This is more than the cliché of “thinking outside the box.” It involves new ways of approaching and looking at the problem of providing customer value.
6. Failure to wish for more. Satisfaction with the current state of affairs or with the means of solving particular problems translates into an inability to look at new ways of providing value to customers.
7. Failure to try to be creative. Many people mistakenly think that they are not at all creative. This means you will never try to produce new types of solutions to the ongoing problems.
8. Failure to keep trying. When attempting to provide new ways to create customer value, individuals are sometimes confronted with creative blocks. Then they simply give up. This is the surest way to destroy the creative thinking process.
9. Failure to tolerate creative behavior. Organizations often fail to nurture the creative process. They fail to give people time to think about problems; they fail to tolerate the “odd” suggestions from employees and limit creativity to a narrow domain.
One of the great mistakes associated with the concept of innovation is that innovation must be limited to highly creative individuals and organizations with large research and development (R&D) facilities. [39] The organization’s size may have no bearing on its ability to produce new products and services. More than a decade ago, studies began to indicate that small manufacturing firms far exceeded their larger counterparts with respect to the number of innovations per employee.[40]
A more recent study, which covered the period from 2003 to 2007, showed that R&D performance by small US companies grew slightly faster than the comparable performance measures for larger US firms. During that period, small firms increased their R&D spending by more than 40 percent, compared to an approximate 33 percent increase for large companies. These smaller firms also increased their employment of scientists and engineers at a rate approximately 75 percent greater than larger companies. Further, the results of this study, which are presented in Figure 4.6 “R&D Intensity by Firm Size”, illustrate that particularly since 2004, smaller businesses have outpaced their larger rivals with respect to R&D intensity. The term R&D intensity refers to the current dollars spent on R&D divided by a company’s reported sales revenue.[41]
Figure 4.6 R&D Intensity by Firm Size
It cannot be over emphasized that innovation should not be limited to the creation of products or services. The following are just a few examples of innovation beyond the development of new products:
• In 1965, Thomas Angove, an Australian winemaker, developed the idea of packaging wine in boxes that had a polyethylene bladder. The package was not only more convenient to carry but also kept the wine fresher for a longer period of time. [42]
• Apple’s iPod was certainly an innovative product, but its success was clearly tied to the creation of the iTunes website that provided content.
• Baker Tweet alerts customers via Twitter any time a fresh batch of baked goods emerge from a participating baker’s oven.[43]
• Patrons at Wagaboo restaurants in Madrid can book specific tables online.[44]
• Restaurants often mark up bottles of wine by 200 percent to 300 percent. Several restaurants in New York, Sydney, and London have developed relationships with wine collectors. The collectors may have more wine than they can possibly drink, so they offer the wine for sale in the restaurant, with the restaurant selling it at a straightforward markup of 35 percent. This collaboration with customers is beneficial for the wine collector, the restaurant, and the customer.
Video Clip 4.13- Vijay Govindarajan: Innovation Is Not Creativity
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
An interview with Vijay Govindarajan on the difference between creativity and innovation.
Video Clip 4.14- Where Good Ideas Come From
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
This cartoon was developed for Steven Johnson’s book on innovation. He concluded that with today’s tools and environment, radical innovation is extraordinarily accessible to those who know how to cultivate it. Where Good Ideas Come From is essential reading for anyone who wants to know how to come up with tomorrow’s great ideas.
Video Clip 4.15- Steven Johnson: Where Good Ideas Come From
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
This relatively long presentation (eighteen minutes) by Steven Johnson maps out the ideas presented in his book.
Video Clip 4.16- Encouraging Innovation with Employees: Innovators Forum Guest Danika Davis
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Danika Davis, Innovators Forum guest and CEO of the Northern California Human Resources Association, discusses the ways to reward innovation among employees and how to foster innovation in your small business.[45]
Video Clip 4.17- Creating an Innovation Mind-set
https://youtube.com/watch?v=sNzkmZdM4A4
Vijay Govindarajan discusses that to create an innovation mind-set, managers must bring in fresh voices from outside the company, encourage collaboration, and consider how emerging market needs can spur ideas for innovative offerings.
Video Clip 4.18- Tom Peters: Innovation Is Actually Easy!
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=48
Tom Peters declares war on the worthless rules and absurd organizational barriers that stand in the way of creativity and success.
Video Clip 4.19- How to Spot Disruptive Innovation Opportunities
https://youtube.com/watch?v=KGzXWO_anLI
Disruptive innovation occurs when an innovator brings something to market that is simple, convenient, accessible, and affordable. Here are some tips to help you pinpoint disruptive opportunities within your organization.
Social and Consumer Trends
Not all businesses have to concern themselves with social and consumer trends. Some businesses, and this would include many small businesses, operate in a relatively stable environment and provide a standard good or service. The local luncheonette is expected to provide standard fare on its menu. The men’s haberdasher will be expected to provide mainline men’s clothing. However, some businesses, particularly smaller businesses, could greatly benefit by recognizing an emerging social or consumer trend. Small businesses that focus on niche markets can gain sales if they can readily identify new social and consumer trends.
Trends differ from fads. Fads may delight customers, but by their very nature, they have a short shelf life. Trends, on the other hand, may be a portend of the future. [46] Smaller businesses may be in a position to better exploit trends. Their smaller size can give them greater flexibility; because they lack an extensive bureaucratic structure, they may be able to move with greater rapidity. The great challenge for small businesses is to be able to correctly identify these trends in a timely fashion. In the past, businesses had to rely on polling institutes for market research as a way of attempting to identify social trends. Harris Interactive produced a survey about the obesity epidemic in America. This study showed that the vast majority of Americans over the age of 25 are overweight. The percentage of those overweight has steadily increased since the early 1980s. The study also indicated that a majority of these people desired to lose weight. This information could be taken by the neighborhood gym, which could then create specialized weight-loss programs. Recognizing this trend could lead to a number of different products and services.[47]
In the past, the major challenge for smaller businesses to identify or track trends was the expense. These firms would have to use extensive market research or clipping services. Today, many of those capabilities can be provided online, either at no cost or a nominal cost.[48] Google Trends tracks how often a particular topic has been searched on Google for a particular time horizon. The system also allows you to track multiple topics, and it can be refined so that you can examine particular regions with these topics searched. The data are presented in graphical format that makes it easy to determine the existence of any particular trends. Google Checkout Trends monitors the sales of different products by brand. One could use this to determine if seasonality exists for any particular product type. Microsoft’s AdCenter Labs offers two products that could be useful in tracking trends. One tool—Search Volume—tracks searches and also provides forecasts. Microsoft’s second tool—Keyword Forecast—provides data on actual searches and breaks it down by key demographics. Facebook provides a tool called Lexicon. It tracks Facebook’s communities’ interests. (Check out the Unofficial Facebook Lexicon Blog for a description on how to fully use Lexicon.) The tool Twist tracks Twitter posts by subject areas. Trendpedia will identify articles online that refer to particular subject areas. These data can be presented as a trend line so that one can see the extent of public interest over time. The trend line is limited to the past three months. Trendrr tracks trends and is a great site for examining the existence of trends in many areas.
Online technology now provides even the smallest business with the opportunity to monitor and detect trends that can be translated into more successful business ventures.
Websites
Key Takeaways
• Small businesses must be open to innovation with respect to products, services, marketing methods, and packaging.
• Creativity in any organization can be easily stifled by a variety of factors. These should be avoided at all cost.
• Small businesses should be sensitive to the emergence of new social and consumer trends.
• Online databases can provide even the smallest of businesses with valuable insights into the existence and emergence of social and consumer trends.
Exercises
1. Generate a new product or service idea. You should be able to describe it in two or three sentences. Work with your fellow students in groups of three to four and then ask them to review their ideas and select one for presentation in class. At the end of the presentation, everyone should write what he or she saw as occurring during the process of group decision making. Did it make the process more creative? Did it allow for the better evaluation of ideas? Do they see problems with this type of group innovation thinking?
2. In Exercise 1, students were asked to develop a new product or service. Repeat this exercise but now ask students to think up an innovation for an existing product in the area of either packaging or marketing. Again, ask them the following questions after the group decision-making process: (a) Did it make the process more creative? (b) Did it allow for the better evaluation of ideas? (c) Do they see problems with this type of group innovation thinking?
3. Consider that you are at the gym mentioned earlier in this section. This gym is considering adding a weight-loss program. Use some of the online tracking programs with respect to the term weight loss program. What useful information could be extracted from these searches?
The Three Threads
Learning Objectives
1. Understand that providing customer value can have a tremendous positive impact on a firm’s cash flow.
2. Understand that determining customer value is critical to the survival of any business. Customer relationship marketing software, which previously was available only to the largest firms, is now priced so that even small firms can extract their benefit.
Focusing on Providing Value to the Customer
The entire thrust of this chapter has been on the topic of customer value. The essence of the argument presented in this chapter has been that any business that fails to provide perceived customer value is a business that will probably fail.
Value’s Impact on Cash Flow
It is not that difficult to envision how the successful creation of customer value can significantly enhance a firm’s cash flow. Firms that are successful in correctly identifying the sources of value should be able to provide superior customer value. This may produce a direct relationship with their customers. These relationships produce a back-and-forth flow of information that should enable the business to further enhance its ability to provide customer value. A successful relationship enhances the probability of customer loyalty, hopefully building a strong enough relationship to produce a customer for life.
Customer loyalty can have several positive outcomes. Loyalty will result in increased sales from particular customers. This does more than generate additional revenue; as the business comes to better understand its loyal customers, the cost of serving those customers will decrease. Increased sales, with declining costs, translate into a significant boost in cash flow. Customer loyalty also has the benefit of generating positive word-of-mouth support for a business. Word-of-mouth advertising can be one of the most powerful forms of advertising and can be seen as a form of free advertising. It has been estimated that word-of-mouth advertising is the primary factor in 20–50 percent of all purchasing decisions. A study by the US office of consumer affairs (formally known as the Federal Trade Commission) indicated that satisfied customers are likely to tell five other customers about their positive experiences.[49] It is particularly powerful in the case of first-time buyers or with expensive items and those items that require extensive research before purchase.[50] Positive word-of-mouth advertising coming from loyal customers can generate additional sales, which in turn enhances cash flow. The creation of superior customer value combined with an intelligent cost control system inevitably produces superior cash flow.
Digital Technology and E-Environment Implications
In the last decade, firms desiring to better understand the customer’s notion of perceived value relied on customer relationship management (CRM) software. Customer relationship management refers to a service approach that hopes to build a long-term and sustainable relationship with customers that has value for both the customer and the company. It is a generic term covering different software and browser applications that collect information about customers and organize it in a way that may be used effectively by management. This term will be referred to repeatedly throughout this text. CRM can assist small businesses with respect to customer value in the following ways: [51]
• It can assist in identifying and targeting the best customers of a business.
• It can help a company develop individualized relationships with customers, thus improving customer satisfaction.
• It can improve customer service, particularly with the best customers.
• It can help management and employees better understand customers and therefore deliver better value to them.
Although originally designed for large corporations with large budgets, CRM is now available to many firms in the small business environment. In addition to being expensive, original fees-first CRM packages were far too complex for small businesses. [52] Now there are many CRM packages that are specifically dedicated to the small business environment.
To maximize the benefits of the CRM package, several factors should be considered. Small businesses should have a clear idea as to their requirements for the CRM solution. Some questions that should be considered are as follows:[53]
• Is our focus on increasing the number of customers?
• Are we attempting to improve our relationships with our customers?
• Will the CRM package help us with e-mail marketing?
• How are we seeking to more effectively use the Internet to communicate with our customers?
• Will we be able to integrate social media?
In some ways, integrating the CRM package may be easier in the small business than in large business because you can overcome some bureaucratic hurdles. However, you must always recognize that the successful implementation of any software package is highly dependent on your employees.[54]
Perhaps the greatest incentive for small businesses to adopt CRM packages is the advent of cloud computing. Cloud computing, also known as SaaS (software as a service), refers to the situation in which vendor software does not reside on the computer system of a small business. [55] All aspects of the system, from maintenance to backups, are the responsibility of the vendor. This minimizes the need for computing capability by the small business. Cloud computing can significantly reduce the course of acquiring and maintaining such computer programs.
Key Takeaways
• Focusing on customer value improves customer loyalty, which improves cash flow.
• Customer loyalty can translate into positive word-of-mouth advertising, which increases sales and cash flow.
• Customer value can be improved through the correct use of CRM software.
• CRM software was formerly so complex and expensive that it was suitable for large corporations only. Now it can be used by the smallest of businesses to improve customer value.
Exercises
1. Assume you are managing a small business that is experiencing a very rapid increase in sales. Unfortunately, this increase in sales has been accompanied by an increase in customer complaints that your company is letting “things slip between the cracks.” You recognize that the old way of interacting with customers is no longer sufficient. You have a sales force of ten, and you would like to supply each with access to a basic CRM package. Go online and identify several CRM packages that might be appropriate for your business. Specify each package’s capabilities and cost. How would you go about selecting one of these packages? Write a report outlining the information you collected and the logic of your selection.
Disaster Watch
The failure to accurately understand a customer’s notion of perceived value is the surest recipe for complete disaster. This may be a large requirement because in many cases customers may be quite unsure about their own notion of value or have difficulty in explicitly articulating that notion. One would think that larger firms—those with much greater resources—would be in a better position to clearly identify their customers’ notion of value. This does not seem to be the case, however, with all large firms. Even they may stumble in attempting to develop products and services that they believe will meet their customers’ concept of value. In this feature, several noticeable product failures are identified. Almost every failure came from a large corporation. This is because we are much more familiar with the failures of large corporations that invest considerable time and effort into the introduction of new products and services. There is far less press given to the failures of small businesses that misread or misunderstand their customers’ notion of perceived value.
When Your Notion of Value Is Not the Same as Your Customer’s
Perhaps the most famous company failure to adequately gauge customers’ notion of value revolved around the introduction of New Coke. In 1985, Coca-Cola was under great pressure, losing market share to its major rival, Pepsi. In an effort to recapture market share, particularly among the younger segment of the market, Coca-Cola initiated one of the largest market research projects of its time. It conducted extensive taste tests throughout the nation and investigated the possibility of introducing a new formula for Coke. The results from the taste tests were positively skewed toward a sweeter version. There was some debate whether this should be an additional option to the Coke line of products or whether it should replace the standard formula for Coke. Although there were some negative indications about this new formula from focus groups, Coke decided to begin a major introduction of New Coke, but it was universally considered a major disaster. Public reaction, particularly in the South, was very negative toward New Coke. A lot of this negative reaction stemmed from the fact that Coke had become an iconic product in the nation, particularly in southern regions. Hundreds of thousands of people called and wrote to Coca-Cola expressing their dissatisfaction with this decision. [56] Coca-Cola failed to recognize the emotional and social components of value for a significant number of its customers.
Many firms fail to realize that they have established, in the eyes of customers, a very strong sense of how a particular company provides value. These companies may wish to diversify their product or service line while at the same time attempting to exploit their brand name. However, customers may perceive the companies as being so closely identified with the original product that any attempt at diversification may be difficult, if not guaranteed to be a failure. Some examples of this are as follows: Smith & Wesson, noted for handguns, attempted to sell a line of mountain bikes in 2002; Coors beer attempted to sell bottled water; and Colgate toothpaste tried to produce a line of products known as Colgate Kitchen Entrées.[57]
Companies may produce products that run directly counter to their customers’ notion of perceived value. McDonald’s produces value for its customers by offering fast food and a family-friendly environment. Several years ago, in an effort to capture a different segment of the market, McDonald’s introduced the Arch Deluxe hamburger, which was supposedly designed for more adult tastes. Even with a \$100 million marketing campaign, McDonald’s was unable to “sell” this product to its customers.
One health management organization invested more than one third of \$1 million on a computerized member information service. The intention was that this would be more efficient, thus providing greater benefit value to customers. Their mistake was not recognizing that members preferred conversing with human beings. Customers did not want to use a computerized system.[58] Although customers of health-care organizations appreciate factors such as ease of access and reliability, they tend to view with greater importance and value the perceived expression of human compassion.
The dry cleaning business industry in the United States is extremely fragmented. The largest 50 firms control only 40 percent of the total industry’s business. This translates into a simple fact: dry cleaning is still the domain of small business owners, with nearly 35,000 establishments throughout the United States. A decade ago, two firms wanted to change the structure of the industry. Both companies thought that they would be able to provide unique sources of value to customers. Mixell Technologies operates a franchise—Hanger’s Cleaners—that focuses on environmentally responsible dry cleaning. Dry cleaning normally involves some fairly volatile chemicals. Hanger’s Cleaners used a new process developed by Mixell Technology. The belief was that customers would respond to this much more environmentally friendly technology. Initially, the cost of this technology was two to three times the cost of normal dry cleaning equipment. One of the major investors in this firm was Ken Langone, a cofounder of Home Depot. In the same time frame, Tom Stemberg, the founder of Staples, was investing in a dry cleaning franchise called Zoots. Their focus on customer value was the ability to have employees pick up clothes for dry cleaning and drop off the clean clothes at the customer’s home residence or work.[59] Neither business prospered. Mixell has moved on to other applications of its technologies. Zoots has significantly reduced its number of outlets. The reality was that dry cleaning establishments produce low margins and require long hours and close identification with customers. Unfortunately for both businesses, even though they had an experienced executive staff, they failed to correctly identify the true sources of customer value.[60]
1. “Why Customer Satisfaction Fails,” Gale Consulting, accessed December 2, 2011, http://www.galeconsulting.com/index.php?option=com_content&view=article&id= 18&Itemid=23.
2. George Day and Christine Moorman, Strategy from the Outside In (New York: McGraw Hill, Kindle Edition, 2010), 104–10.
3. Forler Massnick, The Customer Is CEO: How to Measure What Your Customers Want—and Make Sure They Get It (New York: Amacom, 1997), 76
4. Sudhakar Balachandran, “The Customer Centricity Culture: Drivers for Sustainable Profit,” Course Management 21, no. 6 (2007): 12.
5. M. Christopher, “From Brand Value to Customer Value,” Journal of Marketing Practice: Applied Marketing Science 2, no. 1 (1996): 55
6. Robert D. Buzzell and Bradley T. Gale, The PIMS Principles—Linking Strategy to Performance (New York: Free Press, 1987), 106.
7. C. Whan Park, Bernard J. Jaworski, and Deborah J. MacInnis, “Strategic Brand Concept Image Management,” Journal of Marketing 50 (1986): 135.
8. Seth, Newman, and Gross (1991) Jagdish N. Seth, Bruce I. Newman, and Barbara L. Gross, Consumption Values and Market Choice: Theory and Applications (Cincinnati, OH: Southwest Publishing, 1991), 77
9. Tony Woodall, “Conceptualising ‘Value for the Customer’: An Attributional, Structural and Dispositional Analysis,” Academy of Marketing Science Review 2003, no. 12 (2003), accessed October 7, 2011, http://www.amsreview.org/articles/woodall12-2003.pdf
10. Ed Heard, “Walking the Talk of Customers Value,” National Productivity Review 11 (1993–94): 21.
11. Wolfgang Ulaga, “Capturing Value Creation in Business Relationships: A Customer Perspective,” Industrial Marketing Management 32, no. 8 (2003): 677.
12. Chiara Gentile, Nicola Spiller, and Giuliana Noci, “How to Sustain the Customer Experience: An Overview of Experience Components That Co-Create Value with the Customer,” European Management Journal 25, no. 5 (2007): 395
13. J. Brock Smith and Mark Colgate, “Customer Value Creation: A Practical Framework,” Journal of Marketing Theory and Practice 15, no. 1 (2007): 7.
14. Robert B. Woodruff, “Customer Value: The Next Source of Competitive Advantage, Journal of the Academy of Marketing Science 25, no. 2 (1997): 139
15. “Maturalism,” Trendwatching.com, accessed June 1, 2012, http://trendwatching.com/trends/maturialism/.
16. “Company Story,” Stew Leonards, accessed October 7, 2011, http://www.stewleonards.com/html/about.cfm
17. Calvin L. Hodock, Why Smart Companies Do Dumb Things (Amherst, NY: Prometheus Books, 2007), 65.
18. “Market Segmentation,” NetMBA Business Knowledge Center, accessed October 7, 2011, http://www.netmba.com/marketing/market/segmentation
19. Jack Schmid, “How Much Are Your Customers Worth?,” Catalog Age 18, no. 3 (2001): 63.
20. Jonathon Lee and Lawrence Feick, “Cooperating Word-of-Mouth Affection Estimating Customer Lifetime Value,” Journal of Database Marketing and Customer Strategy Management 14 (2006): 29.
21. “Loyalty Promotions,” Little & King Integrated Marketing Group, accessed December 5, 2011, http://www.littleandking.com/white_papers/loyalty_promotions.pdf
22. “Determining Your Customer Perspective—Can You Satisfy These Customer Segments?,” Business901.com, accessed October 8, 2011, business901.com/blog1/determining-your-customer-perspective-can-you-satisfy-these-customer-segments.
23. Claudio Marcus, “A Practical yet Meaningful Approach to Customer Segmentation,” Journal of Consumer Marketing 15, no. 5 (1998): 494.
24. Malcolm Goodman, “The Pursuit of Value through Qualitative Market Research,” Qualitative Market Research: An International Journal 2, no. 2 (1999): 111
25. “What Are Wacky WallWalkers?,” DrFad.com, accessed December 2, 2011, http://www.drfad.com/fad_facts/wallwalker.htm.
26. Susan Smith Hendrickson, “Mining Her Peas and Carrots Wins Investors,” Mississippi Business Journal 32, no. 21 (2010): S4.
27. Alain Breillatt, “You Can’t Innovate Like Apple,” Pragmatic Marketing 6, no. 4, accessed October 8, 2011, http://www.pragmaticmarketing.com/publications/magazine/6/4/you_cant_innovate_like_apple.
28. Yoji Akao, Quality Function Deployment: Integrating Customer Requirements into Product Design (New York: Productivity Press, 1990), 17
29. Gerson Tontini, “Deployment of Customer Needs in the QFD Using a Modified Kano Model,” Journal of the Academy of Business and Economics 2, no. 1 (2003).
30. For examples of these applications of QFD, go to http://www.mazur.net/publishe.htm.
31. Glen Mazur, “QFD for Small Business: A Shortcut through the Maze of Matrices” (paper presented at the Sixth Symposium on Quality Function Deployment, Novi, MI, June 1994)
32. For more information and to download a 30-day trial of the QI Macros, including the QFD template, see http://www.qimacros.com/six-sigma-articles.html
33. David Carson, Stanley Cromie, Pauric McGowan, Jimmy Hill, Marketing and Entrepreneurship in Small and Midsize Enterprises (Hemel Hempstead, UK: Prentice-Hall, 1995), 108
34. Malcolm Goodman, “The Pursuit of Value through Qualitative Market Research,” Qualitative Market Research: An International Journal 2, no. 2 (1999): 111.
35. Shallee Fitzgerald, “It’s in the Cards,” Canadian Grocer 118, no. 10 (2004/2005): 30
36. communities.cisco.com/community/technology/collaboration/business/blog/tags/innovation.
37. Jerry Katz and Richard Green, Entrepreneurial Small Business, 2nd ed. (New York: McGraw-Hill, 2009), 17
38. Alexander Hiam, Creativity (Amherst, MA: HRD Press, 1998), 6.
39. “Innovation Overload,” Trendwatching.com, accessed December 2, 2011, trendwatching.com/trends/pdf/2006_08_innovation_overload.pdf
40. A. Roy Thurik, “Introduction: Innovation in Small Business,” Small Business Economics 8 (1996): 175.
41. L. Rausch, “Indicators of U.S. Small Business’s Role in R&D,” National Science Foundation (Info Brief NSF 10–304), March 2010.
42. Jancis Robinson, “The Oxford Companion to Wine,” 2nd ed., Wine Pros Archive, accessed October 8, 2011, http://www.winepros.com.au/jsp/cda/reference/oxford _entry.jsp?entry_id=430.
43. “Innovation Jubilation,” Trendwatching.com, accessed December 2, 2011, trendwatching.com/trends/innovationjubilation.
44. “Transparency Triumph,” Trendwatching.com, accessed December 2, 2011, trendwatching.com/trends/transparencytriumph.
45. Discuss this and other topics at http://blogs.cisco.com/category/smallbusiness
46. MakinBacon, “Why and How to Identify Real Trends,” HubPages, accessed October 8, 2011, hubpages.com/hub/trendsanalysisforsuccess.
47. “Identifying and Understanding Trends in the Marketing Environment,” BrainMass, accessed June 1, 2012, http://www.brainmass.com/library/viewposting.php?posting_id=51965.
48. Rocky Fu, “10 Excellent Online Tools to Identify Trends,” Rocky FU Social Media & Digital Strategies, May 9, 2001, accessed October 8, 2011, http://www.rockyfu.com/blog/10-excellent-online-tools-to-identify-trends.
49. James L. Heskitt, W. Earl Sasser, and Leonard A. Schlesinger, The Service Profit Chain (New York: Free Press, 1997): 88.
50. Colette Weil, “Word-of-Mouth Marketing,” Home Care Magazine 33, no. 1 (2010): 49.
51. “CRM (Customer Relationship Management,” About.com, accessed October 8, 2011, sbinfocanada.about.com/cs/marketing/g/crm.htm.
52. Maria Verlengia, “CRM for the Small Business, Part 1: When Is It Time to Invest?,” CRMBuyer, February 16, 2010, accessed October 8, 2011, http://www.crmbuyer.com/story/69349.html.
53. Maria Verlengia, “CRM for the Small Business, Part 2: Choosing the right CRM Tool,” CRMBuyer, February 23, 2010, accessed October 8, 2011, http://www.crmbuyer.com/story/69402.html.
54. Maria Verlengia, “CRM for the Small Business, Part 4: Getting the New System Up and Running,” CRMBuyer, March 9, 2010, accessed October 8, 2011, http://www.crmbuyer.com/story/69502.html%22.
55. “Great Customer Relations Management Tools,” St. Germane, accessed June 1, 2012, http://www.stgermaine.ca/great-crm-customer-relationship-management-tools/.
56. Constance L. Hayes, The Real Thing: Truth and Power at the Coca-Cola Company (New York: Random House, 2004), 211.
57. “The Top 25 Biggest Product Flops of All Time,” Daily Finance, accessed December 2, 2011, http://www.dailyfinance.com/photos/top-25-biggest-product-flops-of-all-time.
58. Scott MacStravic, “Questions of Value in Healthcare,” Marketing Health Services 17, no. 4 (1997): 50.
59. “An Analysis of the Competitiveness Strategies of Zoots,” Cebu Ecommerce Writing Consultancy, accessed June 1, 2012, http://cebuecommerce.info/an-analysis -of-the-competitive-strategies-of-zoots-the-cleaner-cleaner/.
60. Companydatabase.org, accessed June 1, 2012, http://companydatabase.org/c/ recyclables-pick-up-service/products-services/zoots-corporation.html. | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.01%3A_Chapter_4-_Your_Business_Idea-_The_Quest_for_Value.txt |
The small in small business refers only to the number of employees or the volume of sales. It seldom refers to the level of enthusiasm, the amount of creativity, or the ability to innovate. A great example of this is Carrot Creative, a new social media agency headquartered in the Dumbo section of Brooklyn, New York. Mike Germano and Robert Gaafar started their first company while Mike was a college student and serving as a city councilman in Hamden, Connecticut. They developed sites that enabled students to sell used textbooks and rate their professors. In 2005, they opened Carrot Creative. When it was in its infancy, Carrot Creative was not a traditional marketing agency, and social media barely existed. The social media industry, as a whole, is one of the most innovative and fast-paced industries in the world, forcing companies such as Carrot Creative to stay ahead of the curve and adapt quickly.
From the very beginning, Carrot Creative has been innovative and progressive—not only because of its founders and team members but also out of necessity. It started with no available business model to copy, no rules to follow, and no resources on which to rely. They had one rule: do not accept the status quo. Carrot Creative was designed to become what its founders envisioned and what the market needed. They view themselves as a business that is always open to a challenge. They dare anyone to present them with a problem that they cannot solve. Germano, in a recent interview, put it this way, “We help brands build on social networks, teach them and help them in great ways for them to have conversations with their customers and really turn brands into people.”[1]
Some of the brands that they have signed include Crayola, the National Football League, Major League Baseball, AOL, Disney, PepsiCo, Budweiser, the Islands of the Bahamas, and Ford Motor Company. Creative Carrot was the driving force behind Ford’s social media campaign for its new Fiesta vehicle. This small business has partnerships with some of the world’s largest advertising agencies and public relations (PR) firms. They also have the honor to be on the forefront of designing the very tools that define social media. They view their title as an official “Facebook Preferred Developer” as just icing on the cake.
Today, Carrot Creative remains on top of the creative game by giving all its employees the freedom to create in their own way. It keeps creativity flowing by cultivating an environment and culture that removes the idea of micromanaging and gives each Carrot Creative employee the freedom, trust, and responsibility for their own work and actions. One never knows when creativity will strike, but it certainly will not be inside a cubicle or under someone’s thumb. Creativity flows through individual expression and personal work style. The Carrot Creative office is designed for just those things. There is space to work on couches, in a room of Astroturf, and private offices with maple desks, and, most importantly, the ability to be freely collaborative. As Germano said, “We appreciate the individual nature of small companies.”[2]
Personal Efficiency and Effectiveness
Learning Objectives
1. Recognize the difference between effectiveness and efficiency.
2. Understand the differences among first-, second-, third-, and fourth-generation time-management systems.
3. Learn how using an activity log to see how time is spent.
4. Learn the dos and don’ts of time management.
Open any basic management textbook, and there will always be a discussion of the importance for an organization to be both effective and efficient. These are fundamental concepts. An organization demonstrates effectiveness when it achieves the outcomes that it wishes to produce. [3] Efficiency is “the capacity of an organization, institution or business to produce the desired results with the minimum expenditure of energy, time, money, personnel, material, etc.”[4] In discussing the distinction between the two concepts, Peter Drucker once said, “Efficiency is doing things right; effectiveness is doing the right things.”[5] Regardless of the exact definition of these concepts, it should be clear that any business should strive to be both effective and efficient.
It is important to recognize that for any given endeavor, one can be effective but not efficient and vice versa. This can be illustrated with the following example. Two students are working in their college mail room. Each is given a stack of five hundred individual class schedules that are to be sorted and placed in the mailboxes of the undergraduate students. They are told that when they are done, they will be given another job. The first student is meticulous and carefully checks that each class schedule goes to the right recipient. She completes the job in 4.5 hours. The second student is less careful about accuracy and makes several errors by putting the wrong schedule in the wrong box. However, he completes his work in 3 hours. The first student was effective because the task was to get the right schedule to the right student. The second student was more efficient, if efficiency is measured in the number of schedules dispensed per hour.
In the late 1950s and early 1960s, two important works on the nature of a firm introduced an expanded concept known as “organizational slack.” Slack was seen as the excess capacity maintained by an organization. By definition, slack implies that an organization is not perfectly efficient. Some argue that slack provides resources for innovation and change. Others see it as a buffer for a firm. [8] Although these debates might make for interesting academic discussions, it must be recognized that most small businesses do not have the luxury of maintaining any appreciable slack. Their survival hinges on being both highly effective and highly efficient. Therefore, any technique, program, or methodology that improves those ends is vital to the well-being of a small business.
Time Management
Strategy is the art of making use of time and space. I am less concerned about the latter than the former. Space we can recover, lost time never.[9]
Napoleon
Throughout this chapter, the focus will be on the simple fact that one of the great enemies in life—particularly a businessperson’s life—is the existence and acceptance of waste. One of the resources that we can least afford to waste is time. In many ways, time is the most precious of all resources. Other resources can often be purchased or acquired, but time cannot be purchased. Once lost, time can never be recaptured. Time, as a resource, should be of particular importance for the small business owner.
If one is serious about maximizing the use of time, then one should consider two venues: use a time-management system and avoid what are referred to as “time wasters.” The term time-management system is a broad concept and covers many different approaches. Regardless of the approach used, its adoption provides multiple benefits. As one author puts it—“‘Time management’ involves working on the right things [effectiveness] and doing them the best way [efficiency].”[10] Steven Covey, author of First Things First,[11] a “bible” for time management, identifies four generations of time-management systems. He defines a first-generation time-management system as being composed of essentially a list of tasks that must be done. A second-generation time-management system, ties deadlines to those tasks. A third-generation time-management system incorporates task prioritization. Many business people are familiar with paper-and-pencil or computerized systems for listing tasks, noting their due dates, and prioritizing them in terms of relative importance. Covey argues for a fourth-generation time-management system. This system is designed to bring balance into the personal and the professional lives of individuals. It is best illustrated by Covey’s 2 × 2 matrix, where one axis is composed of tasks that can be categorized as urgent or not urgent. The other axis is composed of tasks that can be characterized as either important or not important (see Figure 5.1 “Time-Management Matrix”). He emphasizes that those tasks that might be found in the important/not urgent quadrant (quadrant 2) might be critical to an individual’s well-being. Unfortunately, because they are listed as not urgent, they might fall by the wayside. His goal is to produce a “balanced manager.” This balance refers to what he argues are the four fundamental human needs: physical needs, social needs, mental needs, and spiritual needs. His approach to time management is based on valuing relationships and recognizing that the proper management of relationships will reduce the amount of time wasted in activities.
Figure 5.1 Time-Management Matrix
Covey advocates that an individual should have a deep understanding of what is important in one’s life and recognize that, on any day, one will assume different roles. Both elements need to be incorporated into the time-management system. For Covey, we all have to assume different roles in our personal and professional lives. The objective is to identify what these roles require time-wise and how they can be successfully integrated. To achieve integration, we need to better understand ourselves. Covey suggests that developing a personal mission statement is vital to achieving balance. Some characteristics of such a statement might include the following:
• What represents the deepest and best within a person?
• What is an expression of a person’s unique capacity to contribute to one’s family, the organization, and the world at large?
• What represents pursuits that are higher than self-interest?
• What integrates all four fundamental human needs?
• What principles produce quality-of-life results?
• What inspires a person?
The following is an example of a personal mission statement that uses the Covey approach:
I am at my best when I am challenged by a task that has some significance;
I will try to prevent times when I have to work with individuals who think only of their own advancement;
I will enjoy my work when my company provides customers with value and earns a profit;
I will find enjoyment in my personal life when I feel that I have done something that benefits all members of my immediate family;
I will find opportunities that will allow my firm to double its sales every three years;
I can do anything I set my mind to; I will grow my business to the point where I can retire when I am 55;
My life’s journey is building my business and providing a comfortable life for my family;
I will be a person who has created a business that provides value to its customers, and I will be an individual who made his family understand how much he loved them;
My most important future contribution to others will be that I expanded my business’s operations so that I might provide opportunities and gainful employment for additional workers.
I will stop procrastinating and start working on the following:
Broadening the products offered by my business;
Being more tolerant of others who hold conflicting opinions;
Developing plans for my retirement.
I will strive to incorporate the following attributes into my life:
The ability to make all individuals who work for my business feel as though their views are valued and counted;
Illustrate to others that one does not have to limit oneself to a narrow domain of interests;
Never give up regardless of the difficulty of a situation.
I will constantly renew myself by focusing on the four dimensions of my life:
Exercise;
Greater tolerance for others;
Find more time for reading;
Control my temper.
Covey’s complete system of time management is comprehensive and is supported by both paper-and-pencil and software support materials.
If Covey’s comprehensive approach appears to be initially overwhelming, where else might a person begin to improve their time-management skills? An excellent—in fact a critical—takeoff point would be to ask the following question: “Where has the time gone?” How often have we asked ourselves or heard others pose this question, and how often are we unable to answer it? Until one has a solid idea of how time is spent, it is impossible to manage time effectively. It is comparable to beginning a journey to a location without knowing the exact starting point. An excellent way of knowing how time is spent is to use an activity log.
An activity log involves writing down every task and activity a person is involved with during a day. It also requires noting when these activities occurred during the day and how long they lasted. It would be very useful to also comment on one’s emotional state and energy level while performing these tasks and activities. The log should be maintained for a period of time—generally one or two weeks. At the end of this period, analyze how time was spent. This analysis should look for some common threads:
• How much time per day or week is spent on particular activities?
• When during the day did you feel the most productive?
• When during the day did you feel the least productive or have the most disruptions to workflow?
• What activities were individuals who created these disruptions to workflow?
• What activities seem to provide little or no value?
The goal of this analysis is to identify what task or activity should be eliminated and when, if there is a pattern to productivity, a high-value challenging task should be scheduled. The activity log should provide useful insights into how a person should structure time flow.[14]. As one author put it, “Find your rhythm and schedule around.”[15]
After identifying workflow patterns, then seriously begin planning for time management. The first stage of this process involves identifying the required tasks to be performed across various time horizons, such as the upcoming year, month, week, or day. Draw on Covey and others to include a broad spectrum of life activities, not just work-oriented activities. [16]
In addition to identifying these tasks, it is vital that a person prioritize these tasks. Some tasks are clearly more important than others. As an example, securing a major sale would have a much higher priority than selecting the appropriate stationery for a business. The next step is determining—or more likely estimating—how much time and what resources will be required to complete the tasks. Use these estimates of time to generate a to-do list specifying the completion date for the tasks and the activities. Plan on working within realistic blocks of time. [17] When dealing with a large complex project, learn to break it down into manageable segments and components.
It is one thing to create a prioritized time schedule; it is something entirely different to successfully follow such a schedule. Time management involves learning how to consistently carry out these tasks while avoiding the many time-robbing traps that exist in all our lives. [18]
The following are some dos and don’ts of time management:
• Learn to “chunk.” Chunking is a process by which similar activities are grouped into common blocks of time. As an example, one might schedule several activities associated with the financial operations of the business—such as paying bills, tallying receipts, and so forth—together during a specific time period. [19]
• Learn to delegate. A common complaint leveled at entrepreneurs and small business owners is their propensity to be involved in every aspect of the business. The effective use of one’s time will involve recognizing that one person cannot do everything. It is important to learn how to delegate a particular task to subordinates. The challenge is to properly supervise the subordinates so that the task is carried out as desired.[20]
• Learn to say “no.” It is often said that the most important word for a manager to learn is the word no. Time management involves discipline. It means that at times we must stop activities that would become time robbers. [21] What about the colleague who drifts into your work space and asks, “Do you have a few minutes?” When we know that this colleague will be talking more about his or her own personal life rather than work-related activities, then we must have the courage to say, “Sorry, but I do not have the time.” In periods of time pressure, we must even find strength to forgo some activities, such as going out to lunch.[22]
• Learn to not procrastinate. For many of us, this is the great challenge. It is best dealt with by maintaining a clear focus on the required tasks. This is why a to-do list of tasks tied with prioritization is so important. One way to deal with procrastination is to concentrate on one task and staying with the task until it is complete.[23] Another form of procrastination is the willing acceptance of wasting time. Waiting is a form of wasting time if one is not engaged in some useful activity while waiting for some other outcome—such as working while on hold during a phone call.[24]
• Learn to manage e-mail. One of the greatest sources of time wasting is the improper management of e-mail. The ping announcing a new e-mail message often lures one away from productive work to read the message. One should plan set blocks of time during the day to handle e-mail. Outside these blocks, one should not open any e-mail. E-mail should be approached so that each item can be dealt with once and then eliminated.[25] One should also be prepared to “on deadline days…put up the equivalent of a ‘do not disturb sign.’”[26]
• Learn to find private time. It is vital that an individual find time where to be alone with one’s own thoughts and work in isolation without interruptions. Time to think allows the small business owner to think about the “big picture.” [27] This type of break can actually improve one’s efficiency and effectiveness.[28] As with e-mail, one must be prepared to demand no interruptions.
In addition to these suggestions, one should learn to use some form of time-management system: a paper-and-pencil system, such as a day planner; a computer-based system; or a system that works on one’s smartphone or an iPad. Select one system and stay with it.[29]
Do not become addicted to the rush of constantly being busy. For some individuals, there is confusion between being “on the go” and actually accomplishing what one needs to accomplish. Many of these people view themselves as successful multitaskers. This ability to multitask is often referred to as a modern-day requisite skill. However, the reality is that multitasking appears to reduce one’s productivity. Some studies indicate that multitasking prolongs the accomplishment of a list of tasks by as much as 20 percent to 40 percent. [30] A better use of one’s time is to focus on one task at a time. [31] In conclusion, it is important to recognize that one should not expect to achieve a perfect allocation of one’s time, especially as unexpected events arise. The best that can be hoped for is that “we can actually manage ourselves.”[32]
Video Clip 5.1- Time-Management Tips Are Really Self-Management Tips!
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Harvard Business Publishing covers time management.
Video Clip 5.2- Secrets of Effective Time Management
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Several time-management techniques are discussed.
Web Resources
• Eleven Time-Management Tips, Part 1: Coming to Grips with the Time Management Myth
This site provides useful tips on successful time management. sbinfocanada.about.com/cs/timemanagement/a/timemgttips.htm
• Three Vital Time-Management Principles for Small Business Owners and Entrepreneurs
What principles are key for small business owners and entrepreneurs?
mimosaplanet.com/Small-Business-Blog/bid/55824/3-Vital-Time-Management-Principles-for-Small-Business-Owners-Entrepreneurs.html
• Time Management
Learn how to schedule and manage time wisely and effectively, avoid procrastination, and improve productivity.
www.powerhomebiz.com/leadership/time.htm
• Time-Management Tips for Small Business Owners
Tips that focus on small businesses. ezinearticles.com/?Time-Management-Tips-For-Small-Business-Owners&id=4849540
• Time Management
A sampling of links on time management. www.businesstown.com/time/time.asp
Key Takeaways
• An effective organization achieves the outcomes it wishes to produce.
• Efficiency is the ability of any organization to produce the desired results with the minimum expenditure of resources.[33]
• Time-management systems have evolved through four generations of models.
• Using an activity log can assist anyone in learning how to better manage time.
• Learning the dos and don’ts of time management can significantly improve one’s efficiency.
Exercises
1. Create a time log for a five-day period. Analyze this log and see how you spend time.
2. Identify what you believe to be your own biggest time wasters and how you intend to deal with them.
3. If you do not currently use a formal time-management system, look at several paper-and-pencil or digital versions, evaluate them, and describe which you would select and why.
Creativity
Learning Objectives
1. Understand the three fundamental innovation strategies.
2. Understand what supports creativity in individuals and businesses.
3. Learn what may repress creativity in individuals.
4. Learn about some tools that may help individuals and organizations become more creative.
Money never starts an idea; it is the idea that starts the money.[34]
Owen Laughlin
Thomas Friedman—the author of That Used to Be Us;[35]Hot, Flat, and Crowded; [36] and The World Is Flat[37]—and other pundits consistently argue that the future belongs to those societies and businesses that can best capitalize on creativity and innovation. It is a great tragedy that we often think of creativity and innovation in terms of new technologies only. We fail to realize that creativity and innovation can occur anywhere within a business. There is a story—perhaps it is an urban legend—about a member of the cleaning staff for a company that manufactures shampoo. This employee brought a suggestion to the attention of an executive on the marketing team. The employee pointed out that the instructions on the back of the bottle of shampoo said—“Lather and rinse” and suggested that it should read “Lather, rinse, and repeat.” It may be apocryphal and somewhat unethical, but, if true, it would have led to a significant increase in sales. We recount this legend not to advocate any form of chicanery but to point out that creative insights may come from anyone and anywhere. Creativity is not limited to scientists, engineers, designers, or top executives. It is a property that all human beings possess. Likewise, creativity need not be singularly channeled into new high-tech products or advanced designs. Innovation may pursue different strategies. There are three fundamental innovation strategies for firms: need seeker, a firm that actively interacts with its present and future customers and carefully listens to them so that it can develop new products and services. A market reader is a firm that maintains a close relationship with its customers and provides them value through small innovative changes, and technology driver, a business that puts money into research and development to produce revolutionary breakthroughs and/or incremental changes.[38]
Need seeker firms actively interact with their present and future customers and carefully listen to them so that they can develop new products and services. These firms tend to be the first in the market. A market reader firm maintains a close relationship with its customers and provides them value through small innovative changes. A technology-driven firm is a business that puts money into research and development to produce revolutionary breakthroughs and/or incremental changes. Such a firm spends more time and effort in anticipating future customer needs and carefully listening to what customers believe they want at this point in time. None of these three innovation strategies is clearly superior to the other. It is interesting to know, however, that none of these strategies precludes or minimizes the potential contribution that could come from a small business. If one examines the three innovation strategies, it could be clearly argued that small businesses have an advantage over their larger rivals for the first two strategies. Both rely on a business having a deep and intimate understanding of the needs and desires of its customers. Small businesses also are better positioned to actively listen to their customers and, because of their size, respond more rapidly. Even the third innovation strategy often is the domain of the smaller business. Think of the number of technological breakthroughs that were initiated by smaller firms (at least, smaller at that time) than the large behemoths.
At one level, creativity should be thought of as a rare flower that should be nurtured at both the individual level and the organizational level. Many businesses create an environment that not only does not foster creativity among its personnel but also actively crushes it. Such firms punish any failure, which increases fear in the personnel to try something new. These firms fail to reward innovative successes. They foster groupthink, often responding with the following reply: “We have always done it this way.” The leadership team believes that leaders are the only ones responsible for creative actions. This type of organization is toxic to creativity.
Before examining the tools and techniques that might enhance creativity, it is important to understand what personal and organizational factors might inhibit creativity.
• Accepting the belief that one may not be creative. At a recent sports event, the coach of the team wore a t-shirt that had the following saying: “If you believe you can do something or if you believe you can’t do something, you are right.” Individuals who tell themselves that they are not creative are producing a self-fulfilling prophecy. They will not even attempt to break through barriers that might preclude them from having brilliant, creative, and innovative ideas. It is absolutely vital for the small business owner to be open to the possibility of his or her own tremendous creativity.
• Acceptance of the current situation. Sometimes we assume that the current situation is not only fully acceptable but also the only way that it can be. With that type of mental framework, we never will be in a position even to ask, “How could the situation be made better?” This corresponds with the old idiom, “If it ain’t broke, don’t fix it.” A creative mind is always operating under the assumption that things can be different and can be made better.
• Self-censorship. This is a situation when an idea occurs to us, but we initially consider it too outlandish or too impractical to successfully implement. We dismiss the idea without any further consideration. One does not even take the opportunity to record the idea. We engage in self-sabotage of our own creativity by dismissing our own ideas out of hand.
• Allowing ideas to die. It is not enough to have a creative idea. One must have the courage to defend the idea and the fortitude to see it through to fruition. Unfortunately, individuals adopt the philosophy of W. C. Fields: “If at first you don’t succeed, try, try again. Then quit. No use being a damn fool about it.”[39] A good counterexample of this failure to pursue ideas is the genesis of FedEx. Fred Smith, FedEx’s CEO and founder, was an economics major at Yale University. While there in 1965, Smith wrote a term paper outlining the concept behind FedEx. Legend has it that this paper received a grade of C. Most students would feel that this grade was a clear indication that the concept was infeasible, but Fred Smith was not persuaded, and nine years later he began FedEx. It is not enough to be creative; one also must be courageous.
• Not maintaining a record of ideas. What is called inspiration may be rather fickle. Ideas may come to us in the most unlikely of places and at unexpected times. Individuals should be prepared to make note of these ideas as they come. It might simply require having a notepad available at all times or a digital recorder to take down ideas. Sometimes it is useful to write out the ideas, place them where they are visually accessible, and return to them at some point in the future.
Perhaps one of the most commonly used creativity tools is brainstorming, an approach that emphasizes collaboration within a group. Brainstorming begins by specifying a problem or issue—for example, “How can we boost sales at the restaurant?”; “What can be done to reduce customer complaints?”; or “Why do these particular types of defects keep occurring?” Then one brings together personnel who are directly familiar with the problem or the issue. Sometimes it might be advisable to bring in people not directly familiar with the problem or the issue because they may bring a totally different perspective that might enhance the overall creativity of the problem-solving exercise. The room where the brainstorming exercise is held should be equipped with a whiteboard, or a computer with a projector, or a simple flip chart. The moderator or the facilitator of the brainstorming session should restate the problem. Individuals should be able to shout out possible solutions. The facilitator writes them down or types them into the computer, which is then projected so that all people can see the proposals. The most critical point of the brainstorming session is the openness with which the group accepts any and all ideas. No matter how bizarre or off-the-wall a suggestion might appear to be, no one is allowed to criticize it. Even if an idea is simply crazy, participants do not have the latitude to make any negative remarks. After all the ideas have been presented and written down, the group begins a process of winnowing down the number of suggestions to a smaller number, perhaps five. [40] In the real world, most decisions cannot be done with respect to a simple, single criterion. As an example, one might evaluate the five possible solutions with respect to cost. In the freewheeling environment of brainstorming, one possible solution might yield the lowest cost but might be illegal. Before evaluating the reduced set of solutions, the group must identify all the criteria that would be useful in determining the solutions. Examples of such criteria might be cost, viability, the probability of implementing the solution within a given timeline, or customer acceptance. Once these criteria have been identified, the group can then scale (numerically evaluate) each solution with respect to the criteria. Such an approach should help the group identify the overall best solution. This is the most basic and most common format for brainstorming. Other variations exist that are designed to deal with some possible deficiencies of classical brainstorming, such as naturally reticent members.[41]
Another useful approach to stimulate creative thinking about a problem or an issue is mind mapping. This technique is used widely in a variety of contexts, including creative writing courses. It is a visual model that uses words, phrases, tasks, or concepts centered on an idea or a problem. A node or a figure representing the core notion is drawn at the center. Ideas that are related to this central notion are drawn off, as branches, to the sides. These secondary ideas, in turn, may generate other offshoots. This continues until all interrelationships are mapped on the diagram. Figure 7.2 “Mind Map for Expanding Frank’s All-American BarBeQue” is a mind map that might have been drawn for the restaurant: Frank’s All-American BarBeQue, when it was considering an expansion.
The Financial Monitor from Simione Consultants
William Simione Jr., the founding member of Simione Consultants, has always believed that there has been a need for the home health and hospice industries to have timely financial benchmarks. Recognizing that this need was not being met, Simione started Financial Monitor LLC in 2009. This company launched a product known as the Financial Monitor. This is an excellent example of a business using its creativity to develop a new business. Using the company’s expertise in the home health and hospice industries, Simione designed a program that would benchmark clients’ quarterly financial reports against industry standards. Two principals, William Simione III and David Berman, have managed the development of the Financial Monitor. In 2009, Rob Simione was added to the Financial Monitor team as the senior manager.
The long-term goal of the Financial Monitor is to become the industry’s major database for financial information. Currently, Simione has a database of 160 providers. With this information, Simione not only provides clients with meaningful financial information but also provides the home health and hospice industry with data that can be used in advocacy efforts on both national and state levels. Simione has begun to work with both the National Association for Home Care and Hospice and several state associations to have the Financial Monitor help them in their advocacy efforts. The short-term goal is to have five hundred home health and hospice agencies on the Financial Monitor by end of 2011, and the long-range goal is to have in excess of five thousand on it by the end of 2014.
Video Clip 5.3- TED Fullerton—Matthew Jenusaitis—Importance of Creativity in Business
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
A discussion of the importance of creativity in business. It is seventeen minutes—but very good.
Video Clip 5.4- TEDxPugetSound—Edgar Papke—Creativity and the Human Art of Business
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Discusses how to match creativity and motivation. Another long video, but it has excellent ideas.
Web Resources
• Let Creativity & Imagination Grow Your Business
Discusses the importance of creativity for business development. www.theopensite.com/marketing-business-promotion/small-business-imagination-creativity
• Passion & Creativity Go a Long Way for Small Business Owners
Reviews the critical role of passion for start-ups. www.catalystmarketers.com/passion-creativity-small-business-owners
• Creativity: Breaking the Mental Blocks
How to overcome barriers to creativity. www.smallbusinessadvocate.com/small-business-articles/creativity-breaking-the-mental-blocks-694
Key Takeaways
• All members of an organization can be creative.
• Organizations need to develop environments that support and nurture creativity.
• Mental blocks can stifle an individual’s creative capability.
• Tools such as brainstorming and mind mapping can enhance the creativity of groups.
Exercises
1. What do you believe are your own personal blocks to being more creative?
2. Brainstorm with several colleagues and come up with five innovative concepts for a local restaurant.
3. Draw a mind map for how you might become better in managing time.
Organizational Efficiency
Learning Objectives
1. Understand the eight dimensions of product quality.
2. Understand the five dimensions of service quality.
3. Learn about the Deming philosophy of quality management.
4. Learn about the fundamentals of Six Sigma quality management.
When considering effectiveness or efficiency improvements on an organizational level, one generally thinks in terms of programs: projects with some battery of tools and techniques. Quite often, the businessperson is confronted with choosing from a cornucopia of the most recent business fads. The fad de jour is tried and often found wanting. Eventually, business people become inured to the latest hot trend, continue with their standard operations, and become less willing to try something new. This is extremely unfortunate because some of these programs offer the opportunity for significant improvements. Two such programs are quality management and lean thinking. Both approaches grew out of manufacturing environments. Most of the articles and books about them tend to emphasize manufacturing-based examples. However, this does not mean that they are limited to that domain. More and more service industries are recognizing that the adoption of quality management and/or lean thinking offers tremendous benefits in effectiveness and efficiency. The same can also be said about the acceptance of these business models by smaller firms. Although some quality and lean programs are presented as complete and complex systems requiring extensive training routines, many small businesses have adopted the underlying concepts without resorting to significant expenditures. They recognized that the promulgation of the underlying principles of quality and lean management can yield significant returns without significant expenditures.
Quality Management
Quality is never an accident; it is always the result of high intention sincere effort intelligent direction and skillful execution; it represents the wise choice of many alternatives the cumulative experience of many masters of craftsmanship. Quality also marks the search for an ideal after necessity has been satisfied and mere usefulness achieved.[42]
William A. Foster
Throughout this text, the concept of customer value has been emphasized. Intimately linked to customer value is the notion of quality. Therefore, it is extremely unfortunate that for most people, business people included, the term quality is either totally misunderstood or viewed from a rather narrow perspective. This stems from two reasons. The first is based on a correct assumption that quality is defined by the user (customer); however, many then go on to believe that because quality is subjective, it then becomes impossible to define. The second problem centers on the tendency to view quality, particularly in products, as singularly the result of the use of costly raw materials, components, careful craftsmanship, and detailed processes. It is assumed that together these expensive elements must necessarily produce a quality but costly outcome. In this belief system, if one wants to identify the quality of the product, one has to look only at the price tag. Quality is synonymous with cost. This is a huge error because, as will be shown, a true commitment to quality can reduce costs and expenses—and do so quite significantly.
Quality in Small Business
To see the practical benefits of using the principles of quality management for small businesses, one can simply review the winners of the Malcolm Baldrige Award. This award, started in 1987, seeks to acknowledge businesses that have a solid commitment to quality. Awards were initially given in the categories of manufacturing, service, and small businesses; subsequently, three more categories were added: education, nonprofits, and health care. A sampling of two recent winners in the small business category clearly shows that the smaller enterprise can produce spectacular results by adopting quality management.
K&N Management, a 2010 winner, operates two fast-casual restaurants in Austin, Texas. With a strong commitment to quality, such as using iPads to gather quick survey data from customers, K&N saw its sales increase from \$3 million in 2000 to over \$7.5 million in 2010. Its gross profit was consistently related to quality. In 2010, K&N was named the “best place to work in Austin.”[43]
The 2009 winner in the small business category was Midway USA, an online retailer for gun owners and hunters. Again, Midway USA’s commitment to quality has produced some impressive results. The firm has a customer retention rate of 98 percent. It had a growth rate of 25 percent for 2008, compared to a 10 percent rate for its nearest competitor. From 2003 to 2008, Midway USA saw its net profits increase from 2.5 percent to 10 percent.[44]
These Baldrige award winners are only a few of the indicators that a focus on quality translates into improved customer satisfaction, improved employee satisfaction, and significant improvements to a firm’s financials.
Without a fundamental understanding of what quality really means, it is impossible to achieve it—consistently. So how should one approach a useful definition of the term quality? Many authors suggest that when discussing quality, it is useful to distinguish between product quality and service quality. Today, there may be no clear-cut distinction between exclusively product-based businesses or exclusively service-based businesses. Few products can be viewed in isolation from supporting services. As an example, an automobile manufacturer clearly produces a product; however, few manufacturers would survive long if they totally excluded the area of follow-up services, such as vehicle maintenance across a car’s lifetime. Likewise, many service businesses rely on ancillary products. An investment company provides a service; however, it may also provide its clients with investment perspective reports. Many view McDonald’s as essentially a service company—the service being the delivery of fast food; obviously, the ancillary product is the food.
The literature indicates that rather than having a unitary definition of quality, it is important to identify the dimensions of quality. In a seminal 1984 article, David Garvin identified eight dimensions of product quality: performance, features, reliability, conformance, durability, serviceability, aesthetics, and a diagram that specifies all the types of relationships among key elements of a problem or an issue.[45]Table 5.1 “The Eight Dimensions of Product Quality” describes what these dimensions mean and gives examples. Garvin recognized that no consumer will find all eight dimensions equally important. However, to ensure success, a business must identify which of the eight dimensions are important to its customers. As an example, if we are dealing with a product such as a heart pacemaker, customers would be most interested in the reliability and durability dimensions of that product. If a customer is buying a car for street drag racing only, then that person’s focus would be on the performance dimensions of the vehicle.
Table 5.1 The Eight Dimensions of Product Quality
Dimension Characteristics Examples
Performance, the primary measurable operating characteristics of a product. The primary measurable operating characteristics of a product.
The following outcomes for each category are of greatest importance to consumers:
• Car. Miles per gallon or acceleration time to go from 0 to 60 miles per hour
• Light bulb. Wattage
• Laptop computer. Amount of memory or speed of processor
• Copier. Pages per minute or cost per page
Features, the secondary operating characteristics of a product. The secondary operating characteristics of a product.
The following outcomes for each category may not be initially seen as critical but often influence the purchasing decision of a consumer:
• Car. Comfort of ride or the number of cupholders
• Light bulb. The shade of light given off
• Laptop computer. Size or brightness of the screen
• Copier. Ease of use
Reliability, the probability that a product will function for a given period of time or how often it breaks down. The probability that a product will function for a given period of time or how often it breaks down. This is most often measured by the mean time between failures (MTBF). This is the expectation of how long a product is expected to last.
• Light bulb. Expected lifetime
• Electric watch. Time between replacing batteries
• Copier. Time between replacing toner cartridge or printer drum
Conformance, the extent to which a product matches established standards. The extent to which a product matches established standards. This is viewed by many as the critical component of quality and is the basis of statistical process control.
• Car. How well replacement parts match original equipment manufacturer components
• Laptop computer. Voltage measurements
Durability, the expectation of how long a product will last and how it will function under various working conditions. The expectation of how long a product will last and how it will function under various working conditions. This dimension refers to how well a product lasts over time and under different environments.
• Car. Expected lifetime of engine or tires; how a car functions under temperature extremes
• Laptop computer. Functionality after being dropped
Serviceability, the speed, competence, and courtesy of repairs or maintenance of a product. The speed, competence, and courtesy of repairs or maintenance of a product. This dimension corresponds to the ancillary service component of products.
• Car. The conduct of scheduled maintenance or repairs
• Laptop computer. Speed of return to computer after repairs; intact files after repair
Aesthetics, how a product looks, feels, sounds, tastes, or smells. This is how a product looks, feels, sounds, tastes, or smells. This is the most subjective of the eight dimensions. This dimension means that it is extremely important to consider design issues with respect to any product.
• Car. The attractiveness of the exterior style of the vehicle; the luxuriousness of the dashboard
• Laptop computer. Stylish exterior; unique colors; uniqueness of its operations, such as a new type of input device
Perceived quality, the concept of quality most influenced by brand names, advertising, and commonly held perceptions concerning a product. Consumers often do not have direct evidence of objective measures of a product’s quality—both tangible and intangible measures. This concept of quality is most influenced by brand names, advertising, and commonly held perceptions concerning a product. Powerful brands often provide the perception that a product is of higher quality.
• Car. Rolls-Royce: finest quality car produced and commands a premium price
• Aspirin. Compare prices for same number of tablets: generic bottle versus brand name version—price difference due to perceived quality.
Another approach to examining quality, this time in the service context, is to explicitly consider quality as a comparison between a customer’s expectations and a customer’s perception of performance. Parasuraman, Zeithaml, and Berry argued in their 1985 seminal article that there were ten determinants (dimensions) of service quality: reliability, responsiveness, competence, access, courtesy, communication, credibility, security, knowing the customer, and tangibles.[46] After some major research, they reduced this set to five dimensions: tangibles, reliability, responsiveness, assurance, and empathy. Again, it is critical to note that customers will not view all five dimensions as equally important. In fact, the relative rank of these dimensions may differ significantly across industries. The approach of Zeithaml et al. has become well known as the SERVQUAL instrument, and it plays a prominent role in improving quality in service environments. The five service quality dimensions are given in Table 5.2 “The Dimensions of Service Quality”. This SERVQUAL system explains the notion that quality is associated with a gap between expectations and perceptions. It identifies the following five types of gaps that a service organization should examine and attempt to minimize:
1. The gap between what customers expect and what a business believes are its customers’ expectations
2. The gap between a business’s evaluation of its own performance and how its customers evaluate its performance
3. The gap between a customer’s experience and a business’s specified level of performance
4. The gap between the communicated level of service by a business and what a customer actually experiences
5. The gap between a customer’s expectation and actual experience.
From looking at these five gaps, it should be obvious that a full utilization of the SERVQUAL instrument is quite a challenge and might be beyond the capacity of most small businesses. That does not mean, however, that a business interested in providing its customers with quality service cannot apply some of the elements of the SERVQUAL instrument or use it as a conceptual template.
Table 5.2 The Dimensions of Service Quality
Dimension Characteristics Examples
Tangibles, the physical appearance of a facility, the personnel, and communications media. The physical appearance of the facility, personnel, and communications media. The first thing customers notice is appearances. This may involve the cleanliness of a facility, how brightly lit it is, the width of the aisles, or how personnel are dressed. A cheaply designed website may convey a totally inappropriate message about a business. It should be remembered that a business has only one chance to make a first impression. At its start, McDonald’s emphasized not speed of service but the cleanliness of its facilities.
Reliability, the ability to perform the service correctly and consistently. The ability to perform the service correctly and consistently. Reliability means performing the service correctly each and every time. One failure with a customer may destroy his or her faith in the capability of a business. FedEx emphasizes its guarantee to get a package there overnight—each and every time. An accounting firm must make sure that its clients’ tax returns are done properly and submitted on time.
Responsiveness, the speed and courtesy to customer inquiries. The speed and courtesy to customer inquiries. A customer who is put on “hold” for any length of time is on the path to becoming an ex-customer. This dimension requires all personnel to be well mannered and focus on the needs of the customer. Disney trains its park staff to recognize that they are not responding for the sixtieth time to the same inquiry; they are responding for the first time to the sixtieth individual who is asking that question.
Assurance, the extent to which a customer trusts and has confidence in the service provider. The extent to which the customer trusts and has confidence in the service provider. A medical facility’s survival depends on its customers’ belief that they are receiving excellent medical care. The same is true for any professional service. Trust is built over time and is a fragile commodity.
Empathy, the extent of the quality of individualized attention given to a customer. The extent and quality of individualized attention given to a customer. Empathy should be thought of in terms of a doctor’s “bedside manner.” Customers want to be thought of as individuals, not as numbers. Businesses should avoid using preprinted labels on envelopes because this clearly conveys the image of a mass mailing.
When using the term quality management, we should recognize that there is no universally consistent notion of how one can produce quality products and services. In fact, the quality management movement has been evolving for nearly a century. Perhaps the best way of tracing this evolution is to examine the contributions of some of the key proponents of quality. One of the first bodies of work that should be reviewed is that of Walter A. Shewhart (1891–1967). Similar to two other “quality gurus”—W. Edwards Deming and Joseph Juran (the authors are hesitant to use the term guru because this might question the true value of the work of these individuals)—Shewhart worked for Western Electric Company, a division of AT&T.[48] There he developed what is now known as statistical process control (SPC), a mathematical approach that measures how well products conform to previously determined standards. The goal here is to develop a control chart that would enable an operator to distinguish between the random change associated with any manufacturing process and specifically assignable causes of such change. As an example, a machine produces 0.25-inch diameter bolts. Not all the manufactured bolts will be exactly 0.25 inches in diameter. There will be some natural variation around this value. Rather than test the diameter of every bolt, in SPC, a sample of bolts is tested on a regular basis. Based on statistical analysis, one can determine if this sample is within acceptable limits around the 0.25-inch value. If a sample is not within these acceptable limits, then the machine is shut down, and every effort is made to determine the assignable cause—faulty materials, machine error, or operator error. The benefit of this approach is that one can determine, with a high degree of accuracy, the operational characteristics of the system without the expense of testing every item produced. A full discussion of all aspects of SPC is beyond the focus of this text.
Shewhart’s two books, [49][50] are still available in print and are viewed as the foundation works in the field.
Shewhart also made major contributions in the way we think about implementing a quality program in any organization. He advocated a systematic approach structured in four cyclical phases. This approach is sometimes referred to as the PDCA cycle, (see Figure 5.3 “The PDCA Cycle”) or the Deming cycle. (Yet the Deming cycle is an improper name for the PDCA cycle.) The PDCA cycle calls for a cycle of continuous improvement. The first step is to plan for a change that would lead to improvement. The planning process requires data collection to make a decision. Regardless of the approach to quality management, all decision making must be data driven. The second step in the cycle is the do phase. This entails implementing the change. It also implies that a business will implement that change on an experimental basis, meaning that the organization would run a pilot program rather than implementing it throughout the entire organization. The third phase of the cycle is check. This means that after a sufficient period of time following the initial implementation phase, the results are evaluated to ascertain if the change produced the desired effect. If that answer is positive, then the organization moves onto the fourth stage of the cycle (act), where the changes are implemented throughout the entire organization. At the end of the act phase, the process is repeated with respect to some new problem area.
Figure 5.3 The PDCA Cycle
The two other quality gurus who worked with Shewhart at Western Electric Company, as previously mentioned, were Joseph Juran and W. Edwards Deming. Juran’s numerous contributions to the field include the first standard reference work in the field of quality management: [51] He also developed the Juran Trilogy, an approach to quality management that involves three phases: quality control, quality improvement, and quality planning.
Deming was born in 1900 and received an engineering degree from the University of Wyoming and a doctorate from Yale University. During his career, he worked for Western Electric Company, Bell Labs, and the US Department of Agriculture. During the Second World War, he taught SPC methods to thousands of engineers and plant personnel. After the war, Deming worked in Japan with Douglas McArthur’s Office of Supreme Command of Allied Powers. Several years later, he returned to Japan and worked with Japanese scientists and engineers and taught them about SPC. Deming’s work with the Japanese improved his understanding of what must transpire in a business organization to ensure quality products and services.[52] The Japanese recognized his accomplishments by creating the Deming Prize, which is awarded to organizations that exemplify a commitment to quality.
Many consider Deming as the world’s preeminent proponent of quality. In fact, many see him as one of the most important business thinkers of the twentieth century. In a November 1999 issue, Fortune identified Deming, along with Peter Drucker and Frederick Taylor, as three individuals who had more impact on the operations of businesses than any CEO. In its April 22, 1991, edition, US News & World Report covered nine important turning points in human history. The final point was Deming’s impact on the Japanese quality movement.[53]
What distinguishes Deming from all other quality theorists is his comprehensiveness known as the Deming method. It has been stated that Deming proposed an alternative philosophy of doing business. He argued that one should believe that the purpose of a business is to delight a customer. If customers are delighted, then profits will follow. The Deming philosophy was summarized in his fourteen points, which are given in Table 5.3 “Deming’s Fourteen Points”.
Table 5.3 Deming’s Fourteen Points [54]
# Point Explanation
1 Create constancy of purpose toward improvement of product and service, with the aim to become competitive and to stay in business, and to provide jobs. Deming believed that a firm must have a strong future focus. It should be willing to innovate all areas of operations, services, and products with the purpose of improvement and corresponding cost reduction. It must be willing on all levels to invest in these activities.
2 Adopt the new philosophy. We are in a new economic age. Western management must awaken to the challenge, must learn their responsibilities, and take on leadership for change. Businesses can no longer accept given levels of errors, defects, and mistakes. This means that a small business must challenge its own beliefs about acceptable levels of failure.
3 Cease dependence on inspection to achieve quality. Eliminate the need for inspection on a mass basis by building quality into the product in the first place. Inspecting 100 percent of the finished goods produced by a business is wasteful, costly, and without purpose. A business should focus on evaluating every process that is used to produce the product or the service. Using SPC and sampling will achieve better results than 100 percent inspection at a far lower cost.
4 End the practice of awarding business on the basis of price tag. Instead, minimize total cost. Move toward a single supplier for any one item, on the long-term relationship of loyalty and trust. Low price has no meaning if a customer is buying poor quality. It is better to find a business that can ensure the quality of the goods (or services) rather than attempting to play off several suppliers to achieve a lower price. This is a central tenet in supply chain management.
5 Improve constantly and forever the system of production and service, to improve quality and productivity, and thus constantly decrease cost. The focus of a quality management program should be on processes rather than merely looking at outcomes. The goal is to consistently improve these processes. This will result in lower cost and better utilization of labor.
6 Institute training on the job. A training program should recognize that people learn in different ways. The training program should be tailored to the learning style of the employees. The central focus of any training program throughout an organization should be to make employees aware of the problems associated with variation.
7 Institute leadership. The aim of supervision should be to help people and machines and gadgets to do a better job. Supervision of management is in need of an overhaul, as well as supervision of production workers. Businesses have little trouble finding managers and supervisors; the problem is finding leaders. Leadership involves a deep and thorough understanding of the work that is to be done. Leaders provide the vision to employees that enable them to carry out their work with pride.
8 Drive out fear, so that everyone may work effectively for the company. Fear is often systemic in organizations. It could be the fear of losing one’s job. It can be the fear of making a mistake. It could be the fear of displeasing a supervisor. In all cases, this fear prevents employees from taking an initiative and being innovative. In the long run, this can be fatal for any organization.
9 Break down barriers between departments. People in research, design, sales, and production must work as a team, to foresee problems of production and in use that may be encountered with the product or service. If people in different functional areas of a business do not know what the others are doing, they cannot adopt the perspective that focuses on what is good for the business at large. They focus on only what is good for their silo. A failure to understand the duties and responsibilities of people in other segments of the business means that people engage in finger-pointing rather than aggressively attempting to solve problems on a system-wide basis.
10 Eliminate slogans, exhortations, and targets for the workforce asking for zero defects and new levels of productivity. Such exhortations only create adversarial relationships, as the bulk of the causes of low quality and low productivity belong to the system and thus lie beyond the power of the work force. Exhorting people to work harder is pointless if there are fundamental flaws or problems with the system they are working in. People recognize this and resent it. It makes them doubt the sincerity and intelligence of management.
11
1. Eliminate work standards (quotas) on the factory floor. Substitute leadership.
2. Eliminate management by objective. Eliminate management by numbers, numerical goals. Substitute leadership.
Work standards that do not include a quality component may be detrimental to the operation of a business. Refer to the example at the beginning of this chapter. The second student was superior on the measure of the number of schedules sorted per hour; however, the students who received the wrong schedule would take a dim view of the capability of the college. Deming feels that this holds true for not only production workers but also management. Using the wrong set of numbers that drive the business may drive the business into insolvency.
12
1. Remove barriers that rob the hourly paid worker of his right to pride in workmanship. The responsibility of supervisors must be changed from sheer numbers to quality.
2. Remove barriers that rob people in management and engineering of their right to pride in workmanship. This means, inter alia, abolishment of the annual or merit rating and management by objective.
Employees who do not have a chance for some dignity associated with their work are unlikely to take pride in their work. Pride forces individuals to perform tasks correctly and spot errors. Pride should foster individual initiative to improve processes and quality.
13 Institute a vigorous program of education and self-improvement. Training programs should be available for all levels of employees. Training should not be limited to short-term outcomes; it should focus on providing a deep understanding of the key processes of a business.
14 Put everybody in the company to work to accomplish the transformation. The transformation is everybody’s job. Quality should never be seen as the responsibility of management or a specialized group, such as quality assurance. It is everyone’s job.
Implementing quality management concepts in American business has had a long and somewhat checkered history. In the last four decades, total quality and continuous quality movements have blossomed in popularity and then quickly died. Two decades ago, Walter Lareau argued that many American businesses, particularly large businesses, have an almost pathological antipathy toward quality management because some of its (quality) fundamental principles run totally counter to corporate belief systems, namely, customers are a pain and employees are an even bigger pain.[57] In the intervening time, however, it appears that one approach to quality has captured the imagination of many businesses—both large and small. This quality program is known as Six Sigma.
Although Six Sigma is often associated, at least in the public’s mind, with General Electric, it began at Motorola in the 1980s and was spearheaded by William Smith.[58] The term sigma (σ) comes from SPC and represents the concept of the standard deviation.It is used in SPC models. Six standard deviations away from specifications signify that the process produces only 3.4 defects per million opportunities. This is a remarkable accomplishment. Imagine a restaurant that is open 12 hours a day, 365 days per year. On average, the restaurant serves 1 meal every 55 seconds or about 800 meals per day. It would take them approximately 3.4 years to serve one million meals. So if this restaurant was operating at a Six Sigma level, it would make a mistake in taking an order only once a year. Six Sigma draws on a battery of tools and techniques derived from SPC and earlier quality management programs. Six Sigma’s mantra for continuous improvement involves what is referred to as the DMAIC cycle (see Figure 5.4 “The DMAIC Cycle”), where D stands for design, M stands for measurement, A stands for analyze, I stands for improve, and C stands for control. Clearly, this concept is derived from the Shewhart cycle.
Figure 5.4 The DMAIC Cycle
What was different about the Six Sigma program was that all these tools and techniques were packaged in a coherent program. There was a heavy emphasis on quick results and the ability to demonstrate to management tangible cost savings. Six Sigma involves committed training programs that promote statistical tools and management techniques. Graduates of the most basic certification training program are referred to as “green belts,” a term derived from the martial arts. Those who receive more advanced training are known as “black belts.”[59] Given that Six Sigma is closely associated with large corporate entities and complex training programs, one might think that it would be irrelevant for smaller enterprises. Nothing could be further from the truth. Six Sigma offers a systematic and pragmatic approach for quality improvement in the smaller firm.[60]
Video Clip 5.5- Six Sigma
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
An overview of Six Sigma and a discussion of how organizations use it.
Video Clip 5.6- Pizza Anyone? Six Sigma DMAIC Strategy Introduction
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Explains Six Sigma’s DMAIC strategy in simple, nontechnical terms using the familiar setting of a pizza restaurant business.
Video Clip 5.7- Six Sigma Interview with Jack Welch
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Jack Welch, former CEO of General Electric, talks about implementing Six Sigma at General Electric.
Web Resources
• PDCA Cycle: A description of the Shewhart cycle.
asq.org/learn-about-quality/project-planning-tools/overview/pdca-cycle.html
• Deming’s Fourteen Points: Discusses Deming’s fourteen points and includes links to allied topics.
leanandkanban.wordpress.com/2011/07/15/demings-14-points
• Seven Basic Quality Tools: These seven tools get to the heart of implementing quality principles.
asq.org/learn-about-quality/seven-basic-quality-tools/overview/overview.html
• Seven New Management and Planning Tools: Ways to promote innovation, communicate information, and successfully plan major projects.
asq.org/learn-about-quality/quality-tools.html
Key Takeaways
• Quality for manufactured goods may be defined by using the eight dimensions of product quality.
• Quality in services may be defined by using the five dimensions of service quality.
• Quality should be seen as a continuing cycle (PDCA) of improvement.
• Quality guru W. Edwards Deming offers a complete philosophy of quality management in the workplace.
• The costs of quality improvements are always less than the costs of poor quality; hence quality is free.
• Six Sigma is a modern and highly practical approach to quality improvements.
Exercises
1. Take the eight dimensions of product quality and rank them in terms of relative importance for the following products: a heart pacemaker, a minivan, a laptop computer for high school students, an army assault rifle, an office copy machine, a light bulb, a jet engine, and a pocket lighter.
2. Take the five dimensions of service quality and rank them in terms of relative importance for the following services: a bank, a college classroom, a walk-in clinic, a divorce lawyer’s office, a cell phone service, a credit card company, a financial advisor, and a computer repair company.
3. Assume that your college or university suddenly decided to fully accept the Deming philosophy. How would it have to change? What do you think would be the first change that a student would notice? How would a particular course change if an instructor adopted the Deming philosophy?
Going Lean
Learning Objectives
1. Understand the basic logic of lean thinking.
2. Understand the sources of waste for a manufactured product.
3. Understand the sources of waste for a service.
4. Learn about the five S’s of lean.
Waste is worse than loss. The time is coming when every person who lays claim to ability will keep the question of waste before him constantly. The scope of thrift is limitless.[61]
Thomas A. Edison
The most dangerous kind of waste is the waste we do not recognize.[62]
Shigeo Shingo
Another organization-wide movement that has become popular at a global level during the last two decades is the concept of lean thinking. This concept was first introduced to American business people in the book The Machine That Changed the World: The Story of Lean Production—Toyota’s Secret Weapon in the Global Car Wars That Is Now Revolutionizing World Industry.This book focused on the global automobile industry. It highlighted the significant differences in productivity between Japanese firms, Toyota in particular, and their American and European rivals. At the time the book was written, Toyota was half the size of General Motors; today, on a global basis, Toyota is larger than General Motors. The book highlighted the approach adopted by Toyota, which is, as articulated by Taiichi Ohno, its developer, centered on “the absolute elimination of waste.”
Although lean is most closely associated with Toyota, its central principles are applicable for any small and midsize enterprise. Audubon Media Corporation is a publisher of cookbooks. It adopted a program that included a variety of lean techniques. In a two-year period, it increased sales by 25 percent without increasing staffing, reduced lead time by at least 50 percent, and increased available floor space by 20 percent through inventory reduction and more efficient redesign. Corporate Image, a manufacturer of packaging, adopted lean methods and reduced lead times by over 35 percent and reduced costs by nearly \$180,000 in one year.[64]
Lean thinking is predicated on five major principles.[65]. The first principle can be summarized as follows: know who your customers are and know how they define value. This principle coincides nicely with the underlying philosophy of the quality movement, namely, placing the customer first. Without understanding what the customer wants and what the customer values, an organization runs the risk of producing a wasteful quantity of goods and services that the customer does not want or need.
The second principle of lean thinking centers on determining and visualizing the value stream. The value stream is the entire set of activities associated with the production of goods and services. The goal of such mapping is to identify any and all activities that provide no value to the customer. Once those nonvalue activities have been identified, they are to be eliminated. Students are required, every semester, to go to their advisor and begin the process to register for the next semester or prepare for graduation. Imagine mapping out every step in that process. Having done that, colleges and universities could probably find some steps or activities that do not add value. In a lean operation, those steps would be eliminated. One could also think in terms of the process that most patients face when going to some type of medical facility. They are often required to fill out multiple forms that require the same information. In Figure 5.5 “Value Stream Map for Supplying Hospitals with Blood”, we provide an example of a value stream map for the process of supplying hospitals with blood.
Figure 5.5 Value Stream Map for Supplying Hospitals with Blood [66]
The fourth principle involves a pull system . The term pull means that the production of goods and services is triggered by customer demand. This aspect of lean is what is commonly referred to as just-in-time inventory. The central idea is that the entire value stream is fired up only by customer demand. Thus inventory throughout the system is minimized.
The fifth and last principle is pursuing perfection. This clearly shows that lean thinking is not totally separate and divorced from the concepts of total quality management or Six Sigma. This last principle advocates that removing the impediments to quality will mean a significant reduction in waste. Like Crosby’s work, lean advocates often talk of striving for zero defects.
One of the first steps in any lean program is identifying where waste exists within the system. Taiichi Ohno and Shigeo Shingo, the two cofounders of the Toyota Production System, identified seven possible sources of waste: transportation, inventory, motion, waiting, overprocessing, overproduction, and defects. (A nice mnemonic to remember these seven sources is TIM WOOD.) Table 5.4 “Seven Sources of Manufacturing Wastes” identifies and gives examples of the original seven sources of waste used throughout Toyota.
Table 5.4 Seven Sources of Manufacturing Wastes
Type of Waste Description Examples
Transportation, the movement of components and parts that is not associated with their transformation. The movement of components and parts not associated with their transformation. Unnecessary movement (that which is not required by the customer) runs the risk of damage. When looking for suppliers, Toyota takes into consideration their proximity to its production plants. Toyota plants are designed so that suppliers can bring their items directly to where they will be used on the factory floor.
Inventory, materials not being actively used to meet customer demand represent a waste of capital. The three types of inventory—raw materials, work in process, and finished goods—are all forms of investment. When these inventories are not being actively used to meet customer demand, they represent a waste of capital. Just-in-time inventory strives to produce inventory according to the demand of the customer. Every effort is made to smooth production processes so that there is no need to produce any component in bulk quantities. Many restaurants cook meals only when ordered by the customer. This minimizes leftovers.
Motion, unnecessary motion by employees and equipment. This term refers to employees and equipment, not components or products. Unnecessary motion is a waste of time and money. Like transportation, it runs the risk of damage to the final product or the employees. Excess movement by workers or machinery is to be avoided. Workers and equipment are positioned so that they are in close proximity and movements are minimized. Machines are sometimes grouped in a U-shape so that one worker can operate them with minimal movement.
Waiting, components or products not being processed. If components or products are not being processed, then there is waiting. This represents a waste of investment. Eliminating this form of waste is the reason for the concept of “flow.” Production processes need to be redesigned to minimize the time spent waiting. Special paints are used that dry quickly so that vehicles can move on to the next processing step without having to wait.
Overprocessing, a component or a product that requires more time to process than the standard estimate. A component or a product that requires more time to process than the standard estimate represents a waste. This concept also involves the notion that using inappropriate or excessively complex manufacturing processes or tools also represent a form of waste. The essence here can be summarized by KISS—keep it simple, stupid. This is a well-known engineering principle whereby “less is more.” The process can be accomplished with a simple machine preferable to a complex machine. Simplicity accomplishes the task, minimizes the chance for failure, and reduces waste. A classic example of this would be the engineers who were asked to determine the volume of a complex part. Some began by taking accurate measurements to compute the volume of some segments of the part. Another engineer simply tossed the part into a bucket of water and measured the volume of water displaced.
Overproduction, producing more than a customer wants at a particular point in time. Producing more than the customer wants at a particular point in time is a source of waste. Some businesses have set up operations where they believe that production in large batches is the most economically efficient method. This generally means large inventory levels. Overproduction is seen by some as the driving force behind the other six sources of waste. Lean thinking tasks them to reexamine these basic assumptions. A manufacturer has a good idea of the annual demand of a particular part. Setting up the machine that is used to produce this part is an expense proposition. Financial analysis indicates that the company should produce one batch of the part every quarter (three months’ worth of supply). A three-month supply of the part means that a considerable portion sits in inventory for a long period of time. This quantity of inventory may also mask any defects in manufacturing. It would take quite a while to go through this batch before one would realize that the batch might have had problems in production. A company that focused on reducing the setup cost of the machine could then produce smaller batches, which, in turn, would produce lower inventory levels and therefore catch quality problems earlier.
Defects, the waste and expense of producing defects. Defects in products produce expensive waste—rework costs, scrapping costs, or excess warranty costs. Here is where lean thinking and quality management merge. Poor quality of product and service represents a dramatic waste.
The continued references to the Toyota Production System might lead the reader to believe that lean thinking is appropriate only for the manufacturing environment. That would be profoundly misleading because lean has tremendous applicability to service, particularly in the areas of health care, banking, and retail. Some authors believe that these seven sources of waste are absolutely applicable to service environments.[68] Others have suggested that the original seven sources of manufacturing waste be modified to cover the service environment, as follows: delay, duplication, unnecessary motion, unclear communication, incorrect inventory, errors, and opportunity lost.[69] These seven sources and corresponding examples are described in Table 5.5 “Seven Sources of Service Waste”.
Table 5.5 Seven Sources of Service Waste
Type of Waste Description Examples
Delay, this corresponds to the waiting waste concept. Any instance in which a customer must wait for any aspect of the service. One walks into a fast-food restaurant and finds a long queue (line). Any service time spent in that queue is a delay. Another example of the delay would be waiting on the phone to speak to a sales representative.
Duplication, anytime a customer must repeat any activity unnecessarily. When a customer has to repeat any activity unnecessarily. Patients in a medical facility who have to repeatedly fill out forms would be an example of duplication. A website requires customer input of information, but then the website crashes, causing the customer to reinput the information is another example. Such instances are extremely annoying to most consumers.
Unnecessary Motion, a customer is shuttled between a variety of operations and where each move does not substantially add to value. A customer who is shuttled between a variety of operations and where each move does not substantially add to value. A customer wishes to lodge a complaint. The customer calls the complaint department and then is moved from one sales representative to another. This type of frustration may cause customers to drop the service.
Unclear Communication, the failure to provide clear instructions for any stage of a service. The failure to provide clear instructions for any stage of the service environment. Unclear communication, particularly with respect to instructions to customers, is contained in the entire service experience. Examples would include instructions that are filled with jargon or that easily confuse customers.
Incorrect Inventory, a product is not available to the customer, causing the customer to wait for it. Services often have ancillary products. If a product is not available, the customer has to wait for it. A customer places an online order for multiple items. At the time of the order, the customer is told that all the items are available and will be shipped at once. When the customer receives the order, not all the items are in the shipment, and some items are on backorder. “Murphy’s Law” would dictate that the items on backorder are the ones the customer most wanted.
Errors In Services, this corresponds to defects. Any errors or mistakes associated with either the ancillary goods or the service itself. Telling a customer that the repair service will arrive between 10 a.m. and 1 p.m. and then showing up at 4 p.m. is the type of error that few customers are willing to forgive or forget.
Opportunity Lost, an engagement with the customer to a service environment that is a failure. Every engagement with the customer in a service environment is an opportunity to succeed or fail. Failure can be associated with a bad behavioral interaction with the customer, ignorance about the service, or providing incorrect information to the customer. Services differ from products in many ways. One of the most important is that quality services tend to be in real time. In manufacturing, one can test the product before it is shipped. This does not always occur in services. A few words from a rude clerk can describe the customer’s vision of the company. Subsequent apologies may do nothing to erase this negative image. Providing customers with the wrong information, even about minor details, can also destroy their perception of a company.
Lean thinking uses several techniques to achieve its ends. We have mentioned value stream mapping. Other techniques include just-in-time inventory control, quick changeover (a program to reduce setup times to make it more attractive to produce in smaller batches), Kaisen (a Japanese term that refers to any program that seeks small improvements on a regular basis rather than a huge quality initiative), and visual management (a program of visually presenting key metrics to all personnel so that they can be aware of any and all progress). One technique that has broad application in both manufacturing and service environments is known as the 5 S’s. The five S’s refer to Japanese terms for, in effect, housekeeping.[70] The five Ss, which together strive for simplicity and neatness to improve efficiency and effectiveness, are as follows:
• Seiei or organization. Only those tools and equipment that are absolutely needed are available at any one time. All other equipment is stored away until needed.
• Seiton or orderliness. Every part is in its correct place. The Japanese use pegboards to store tools. They sometime draw an outline of the tool on the board so that it is returned to its correct place.
• Seiso or cleanliness. Work environments are kept immaculate. This is done to reinforce the notion of perfect. Some factory floors are painted white so that anything dropped or any litter becomes immediately apparent.
• Seitetsu or standardized cleanup. This is a reinforcement of the prior three points. Starting in Japanese kindergartens, children are required to clean their classroom—together—before they are released to go home.
• Shitsuke or discipline. A program to adhere to set procedures because of pride in one’s own work.
More and more businesses are realizing that lean thinking and quality are not two distinct management approaches but two extremely complementary models. One finds more and more references to a concept known as Lean Six Sigma, which is a program that combines aspects of both lean thinking and quality management. It recognizes that lean by itself cannot bring processes under control, and Six Sigma significantly reduces process time or capital investment.[71] Both approaches offer benefits to small businesses that cannot be ignored if these businesses want to remain viable in an increasingly competitive world.
Video Clip 5.8- Lean Process Improvement—Funny
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
A silent comedy to illustrate lean principles.
Video Clip 5.9- Building a Lean Culture
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Lean requires change throughout an organization.
Video Clip 5.10- Lean Office: Applying Lean to Business Processes
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
Lean is not limited to manufacturing but can be applied to office management.
Web Resources
• Introduction to Lean: A great introduction to lean concepts by a consulting firm.
www.leanthinking.info/aboutlean.html
• Glossary of Lean Tools: Definitions of key terms.
www.shopwerkssoftware.com/lean_glossary.aspx
• Bringing “Lean” Principles to Service Industries: The application of lean concepts to the service environment.
hbswk.hbs.edu/item/5741.html
• Achieving a “Lean Service” Breakthrough: An example of lean concepts applied to the service environment.
www.stratform.com/lean_services.htm
Key Takeaways
• Lean thinking represents a program to eliminate all forms of waste in an organization.
• For any production or service process, one could map out all the currently existing steps and then remove those that do not add value to the customer.
• There are seven sources of waste in manufacturing processes.
• There are seven sources of waste in service processes.
Exercises
1. Interview several local small business owners about how they try to minimize waste.
2. Pick a particular college course you are currently taking and identify sources of waste in that class. How could you redesign that college class to minimize those wastes?
3. Discuss how the 5 Ss approach could be used in your personal life to improve efficiency and effectiveness.
Personnel Efficiency
Learning Objectives
1. Understand the importance of meetings.
2. Understand why meetings fail.
3. Understand the importance of an agenda.
4. Learn about behavioral issues in meetings.
If you had to identify, in one word, the reason why the human race has not achieved, and never will achieve, its full potential, that word would be “meetings.”[72]
Dave Barry
Meetings are indispensable when you don’t want to do anything.[73]
John Kenneth Galbraith
Managing Meetings
As a business grows, it will—in all probability—increase the number of its employees. As the employee base grows, there is increased demand to coordinate activities, exchange information, and engage in decision-making activities. These usually occur at meetings, and one would think that these would be straightforward events. Yet the reality is that many managers and employees come to dread participation at meetings. Data indicate that many, if not most, meetings fail to produce the desired outcome. A study conducted in 1993 found that executives were seen as a spending seventeen hours per week in meetings, and one-third felt that time was wasted.[74] Another survey of thirty-eight thousand managers found that 66 percent felt that the meetings they attend were a waste of time.[75] Still another study found that managers spend as much as 40 percent of their work time in meetings, but only 64 percent of those meetings were seen as achieving their intended outcome;[76] another study found that executives were spending as much as 70 percent of their time at meetings, but only 40 percent of those meetings had clear objectives, and only 28 percent of those meetings with objectives actually met them.[77] Yet 80 percent of the participants viewed running a successful meeting as a crucial test of manager’s abilities.[78] These figures are particularly tragic because so many meetings occur in the business world. One estimate puts the number of meetings, on a daily basis, globally, at 73 million.[79] These are rather depressing figures, but the clear lesson for small business owners is that they cannot afford the luxury of not running their meetings effectively.
The good news is that the successful management of a meeting is a learnable skill.[80] Conducting an effective meeting requires that a manager focus on both procedural and behavioral issues. We will first look at procedural issues associated with running a meeting. Before considering holding a meeting, ask the following question: “Is this meeting really necessary?” Frequent meetings are sometimes held merely out of habit.[81] Can the goals of a meeting be achieved by other mechanisms?[82] These might include using the Internet; e-mail; teleconferencing; or technologies, such as MS Communicator, which allows for bulletin board interaction, voice communication, and videoconferencing. Interestingly, for all the complaints about meetings, a recent study indicated that face-to-face meetings were seen by 95 percent of those surveyed as being positive, especially in the interest of developing long-term relationships. [83]
After deciding that a meeting is necessary, it is important to determine the nature of that meeting. Meetings may have many different types of goals. They can be directed to problem solving, decision making, conflict resolution, providing information, or generating new ideas. This is necessary because the nature of the meeting will drive its structure and internal dynamics. As an example, if a meeting is directed to a decision-making task, it should probably proceed in two parts. The first portion should be directed toward identifying solutions, while the second portion should focus on what might be the best solution.[86] The next decision would be to determine who will participate in the meeting. Ideally, this list would be limited to those who would be directly affected by the outcome of the meeting; however, in the case of informational meetings, the list may be expanded to those who will be directly or indirectly affected. The next decision is associated with determining who will be assigned particular roles in the meeting. The chair is the individual who calls the meeting, provides the initial agenda, and specifies the purpose of the meeting. It may be useful to assign the role of facilitator to an individual. This neutral person can push the meeting along, particularly when conflict arises. It is desirable to have people trained as facilitators and rotate this position among facilitators.[87] Another important role is the individual who is officially assigned to take notes. The notes of the meeting should be written up and sent to all participants in the meeting within two business days. This position should also be rotated among the participants of the meeting. It also might be advisable to assign the role of timekeeper to an individual. The timekeeper has the task of limiting the amount of time spent on any one agenda item to the previously agreed-on time frame.[88]
Perhaps the most important activity prior to the actual meeting is the proper structuring of an agenda. In another study, 75 percent of those surveyed said that a good agenda is critical for a successful meeting.[89] The agenda is the formal strategic plan for a meeting. It is the mechanism for ensuring that a meeting is focused on relevant topics. A failure to have a clear focus will guarantee that the participants will have a sense that nothing had been accomplished.[90] Focus stems from having everyone understand a meeting’s purpose and what one intends to achieve[91]. Items on the agenda should be prioritized in terms of their importance, which is often done by allocating a specific amount of time to each agenda item.[92] Any and all resources that will be required for the meeting should be identified along with the individuals who are responsible for securing the resources. The roles of chair, timekeeper, note taker, and facilitator (where possible) should be assigned in advance. The agenda should be sent out at least five business days before the meeting so that participants can gather the required information. This timeline also allows for people to make suggestions for changing the agenda. It is also highly advisable to make it a policy that all participants arrive on time at the beginning of the meeting. [93]
Allowing individuals to contribute to the agenda will provide them with a sense that they are contributing.[94] In setting the timeline for the different items on the agenda, it is advisable that one allow for a few extra minutes at the end of the meeting to discuss how well the meeting went and how it could be improved.[95] These few moments should be expanded into a formal system. Assessing meeting effectiveness can be done through an external observer conducting an evaluation, focus groups, or surveys.[96]Figure 5.6 “Agenda Format” provides a format for a part of the overall agenda that addresses some of the previous suggestions. It is available as an agenda format wizard in Microsoft Word 2007.
Video Clip 5.11- Business Management and Leadership Skills: How to Conduct an Effective Meeting
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
The basics of meeting management.
Video Clip 5.12- Conducting Effective Small Scale Meetings
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
How to conduct a meeting, even in one’s home.
Video Clip 5.13- How to Avoid Meetings That Suck
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=58
How to escape the traps behind bad meetings.
Web Resources
• Managing Business Meetings: An excellent list of suggestions on business meetings.
www.cbsnews.com/8301-505125_162-51057051/managing-business-meetings/?tag=bnetdomain
• Managing Your Meeting Monsters: Identifying the types of personalities at meetings.
www.impactfactory.com/p/business_meeting_skills_training_development/friends_111-1107-40530.html
Key Takeaways
• Poorly run meetings are common and costly.
• Successful meetings require structure and an agenda.
• The agenda should identify the purpose of the meeting, the participants and their roles, the requisite resources, and agenda topics with timelines.
• Behavioral issues must always be considered when managing a meeting.
Exercises
1. Interview the owners of five businesses and determine what percentage of meetings they attend they find to be “effective.”
2. Ask them what constitutes a bad meeting.
3. Ask them what constitutes a good meeting.
4. Create an agenda for a meeting with a fellow student who came up with an idea for a new business.
The Three Threads
Learning Objectives
1. Understand that in addition to quality management and lean thinking, creativity, time management, and well-executed meetings can improve value to customers.
2. Understand that quality management and lean programs can produce significant increases in operational efficiency that increases positive cash flow.
3. Learn about computer tools that can improve time management, creativity, quality management, and lean operations.
When all think alike, then no one is thinking.[97]
-Walter Lippman
Customer Value Implications
It should be clear that quality management and lean thinking have the notion of customer value at their cores. Both approaches actively incorporate needs and wants into the design of products and services and, even more importantly, into the design of the processes used to create these products and services. Regardless of what quality program one adopts for an organization, the issue of customer value is the single most important question. Lean thinking also recognizes the vital importance of first identifying the customer’s notion of value so that any activity that does not add value is ruthlessly eliminated. As one article put it, “Lean enterprise never misses an opportunity to capture information about customers.”[98]
The linkages between quality management, lean thinking, and customer value, therefore, should be obvious. What is less obvious is the connection between customer value and topics such as creativity, time management, and running meetings effectively. Nonetheless, indirect connections do exist. Without creativity, there will not be any new product development, and there will be no innovations in design, packaging, promotion, or distribution that can be so vital to the enhancement of value.
Owners, managers, supervisors, and employees who cannot manage their time effectively or efficiently will be unable to provide appropriate attention to improving customer value. Poorly run meetings are inefficient and degrade morale; neither is a recipe for enhancing customer value.
Cash-Flow Implications
The old saying “time is money” may be shopworn, but it is an absolute truism. Wasting time inexorably turns into a waste of money. Poor time management means that time is wasted, which costs the individual and the organization.
In a depressed economy, both large and small firms attempt to preserve cash flow by adopting a program of cost cutting. This often begins with laying off employees. However, this presents a rather significant problem. As Nancy Koehn, a business historian at Harvard business School, points out, “If demand picks up, you can’t exploit it because you don’t have the resources.” [99] Lean thinking offers an alternative to cost cutting by reducing staff. Lean thinking, a focus on more intelligent cost-cutting, and the efficient use of all business resources have produced significant results, such as an 80 percent to a 90 percent reduction in inventory investment, an 80 percent to a 90 percent reduction in manufacturing lead times, a 50 percent reduction in space requirements, and a 50 percent reduction in material handling equipment. Such results translate into tremendous cost savings.[100]
Firms that have used the principles of the Toyota Production System have also found that they can achieve a 50 percent reduction in human effort and a 200 percent to a 500 percent improvement in quality. One small manufacturer, Gelman Sciences, adopted a lean approach to operations, and during a nine-month period, one section of the company saw inventory turns go from twenty to fifty-seven, inventory value dropped from \$86,000 to \$33,000, and lead time dropped from three to four weeks to one to three days.[101] Estee Bedding Company applied lean concepts to its operations and reduced its labor cost as a percentage of sales by one-half; Ameripay, a payroll service firm, saw sales increase from \$1.8 million to \$6 million in three years.[102] Some small businesses that are part of a larger supply change may find their movement toward lean thinking supported by firms that are further up the supply chain. In the 1990s, Pratt & Whitney initiated a program to assist smaller firms in its supply chain by requiring them to move to more of a lean focus.[103] Even small foreign firms are beginning to recognize the economic benefits from adopting lean methodologies. A polyvinyl chloride manufacturer in Thailand adopted a lean management program and saw its average production time per unit decline from forty-four minutes to twenty-three minutes while decreasing the number of operators from fifty to forty-one.[104] The concepts behind lean thinking, with its focus on efficiencies, should dictate that a small business should automate as many processes—such as bookkeeping—as possible and rely on outsourcing when feasible.[105]
One does not have to commit to major organizational programs, such as a quality management system or lean thinking, to find ways to save on cash flow. Earlier in this chapter we cited two studies. One said that better than one-third of executives believed that all meetings were a waste, while the second study said that two-thirds of all meetings were a waste. We split the difference between these two studies and arrive at a figure that one-half of all meetings are perceived as useless. This can have significant cash-flow implications, even for small firms.
Let us illustrate this through a simple example. The owner of a small hardware store believes it is important to have weekly meetings with the store’s supervisor and five employees. Let us assume that the owner values his or her time at \$70 per hour. The supervisor’s value is given at \$35 an hour, while each employee’s time is valued at \$10 per hour. Employees are expected to produce 2.5 times their pay. This means that a 1-hour meeting should be valued at \$282.50 [\$70/hour + 2.5 × (5 employees × \$10/hour) + 2.5 × (1 supervisor × \$35/hour)]. Assuming 52 meetings per year, the total opportunity cost for these meetings is \$14,690. If one-half of those meetings are a waste, then the business is losing nearly \$7,350 a year. There are many areas throughout a firm’s operations that can be evaluated to reduce wasteful activities and improve its cash-flow position.
Implications of Technology and the E-Environment
Time-management systems are available in a variety of paper-and-pencil and software formats. They generally allow for listing to-do tasks, setting due dates, identifying required resources, and prioritizing their importance. Some allow for a project format, where one can break down the project into smaller interrelated tasks. Many of them provide the capability to synchronize this information across several computers and smartphones. This would allow a person to have the time-management system available on an office computer, a home computer, and in the pocket (smartphone). One system is based on Covey’s fourth-generation approach to time management.
Multiple software packages are geared to assist individuals and groups who wish to improve their creativity. There are packages to help with brainstorming in its various forms. Numerous companies provide mind-mapping software in a variety of formats: computers, iPads, and even smartphones.
Quality management encompasses many tools and techniques, far more than could ever be covered in this chapter. There are packages geared just for statistical process control (SPC) models. Some can receive data from a process and then automatically inform the operator of a “drift” from conformance to standards. In addition to SPC models, other packages include tools that are used to improve quality. These packages range from less than \$100 to many thousands of dollars.
Web Resources
• Achieve: A time-management system.
www.effexis.com/achieve/planner.htm
• My Life Organized: A time-management system.
www.mylifeorganized.net
• PlanPlus for Outlook v7: A time-management system (based on Covey’s fourth-generation time-management system).
franklincoveysoftware.com/individual/individual-products/planplus-for-outlook-v7
• SciPlore: Mind-mapping software.
en.Wikipedia.org/wiki/SciPlore_MindMapping
• MindManager: Mind-mapping software.
en.Wikipedia.org/wiki/MindManager
• MindMaple: Mind-mapping software.
en.Wikipedia.org/wiki/MindMaple
• MindMapper: Mind-mapping software.
en.Wikipedia.org/wiki/MindMapper
• Creative Whack Pack: Brainstorming software app for the iPad.
itunes.apple.com/us/app/creative-whack-pack/id307306326?mt=8
• Mind View 4: Brainstorming software.
www.matchware.com/mv3be_landing.php?gclid=CKyWyorEiasCFWUZQgodAQjG1Q
• Sigma Magic: Quality management software plus lean components.
www.sigmamagic.com
• Sigma XL: Quality management software
www.sigmaxl.com
• SPC XL: Quality management software add-in for Excel.
www.sigmazone.com/spcxl.htm
• Lean Tuppas Software: Quality management software.
www.tuppas.com/lean-manufacturing-software/lean-manufacturing-software.htm
Key Takeaways
• Customer value can be enhanced not only through organizational programs such as quality management and lean thinking but also by increasing creativity, time-management skills, and meeting effectiveness.
• Quality management and lean programs can generate efficiencies that produce significant cost savings.
• Software exists that can assist with improving one’s own time management.
• Similar programs are available to improve the creativity of teams and support both quality and lean improvement programs.
Exercises
1. Evaluate several computerized time-management systems and write a report covering your selection process.
2. Evaluate several creativity packages and select one that you might buy. Write a one-page paper that talks about why you selected this package.
3. Assume you are a small manufacturer of hypodermic needles. You have sixty employees, and sales are \$23 million. You are nervous about overseas competitors, whose products are getting better. You want to further improve your quality and may be interested in applying lean thinking to your operations. Evaluate several software packages and write a report specifying why you support the acquisition of this package.
Disaster Watch
Successful small business owner often rapidly acquire a sixth sense—one that warns them of impending dangers. They begin to sense when there are changes in consumer preferences, when there is a need for an infusion of additional financial resources, or when closer attention needs to be paid to cash flow. These are fundamental issues, and the failure to recognize them will lead to disaster. Subtler issues associated with operations are sometimes missed, and just because they are less obvious does not mean that they cannot be as dangerous. Small businesses can die when they fail to focus on the necessity of being efficient. As said by one commentator, “As the economy grows leaner, this focus on efficiency is paramount to SMEs [small and midsized enterprises], and may indicate chances of business sustainability.”[106]
In personal efficiency and effectiveness, time is identified as perhaps the most vital resource, since once lost it can never be recovered. This perspective may be particularly true for small businesses. Most small businesses are under tremendous financial pressures. They normally don’t have the luxury of having large staffs, and this means that much of the work falls on the shoulders of the owner. Those owners who cannot effectively manage their time are asking for problems in their business and personal lives.[107] Their businesses can suffer because the owners don’t have sufficient time to generate new business.[108] Family life suffers because the owner’s inability to successfully manager his or her time translates into time inefficiently spent at work.
Small business is often touted, correctly, as the driving mechanism for innovation in this country. The implication is that innovation and creativity in small business is limited to the development of new products and services. This belief can be disastrous for any small business because it may preclude creative innovations in other areas, such as operations and marketing. Recognizing this as a possibility, IBM has begun to operate “boot camps” to instruct smaller business how to fully exploit social media to drive sales.[109]
A failure to maintain a clear focus on quality can have disastrous consequences. While quality in and of itself may not guarantee success, its absence, in the long run, will guarantee failure. Given the complexity of many quality programs and tools, small businesses should overcome a reticence to bring outside quality experts in-house.[110]
Lastly, businesses—large and small—can be slowly poisoned by an unending stream of poorly managed meetings. Those types of meetings waste managers’ and employees’ precious time and can wreck morale.
1. Julie Kanfer, “Brooklyn Tech: Carrot Creative’s Mike Germano,” Brooklyn Heights Blog, May 14, 2010, accessed February 4, 2012, brooklynheightsblog.com/archives/18448.
2. Julie Kanfer, “Brooklyn Tech: Carrot Creative’s Mike Germano,” Brooklyn Heights Blog, May 14, 2010, accessed February 4, 2012, brooklynheightsblog.com/archives/18448.
3. Amitai Etzioni, Modern Organizations (Englewood Cliffs, NJ: Prentice Hall, 1964), 17
4. “Efficiency, Organizational,” Mondofacto, December 12, 1998, accessed February 4, 2012, http://www.mondofacto.com/facts/dictionary?efficiency%2C+organizational.
5. “Peter Drucker Quotes,” Brainy Quote, accessed February 4, 2012, http://www.brainyquote.com/quotes/authors/p/peter_drucker.html
6. James G. March and Herbert A. Simon, Organizations (New York: John Wiley & Sons, 1958), 46
7. Richard M. Cyert and James G. March, A Behavioral Theory of the Firm (Oxford, UK: Blackwell, 1963), 121.
8. Joseph L. C. Cheng and Idalene F. Kesner, “Organizational Slack and Response to Environmental Shifts: The Impact of Resource Allocation Patterns,” Journal of Management 23, no. 1 (1997): 1–18.
9. “Napoleon Speaks on Increasing Market Share,” Stealing Share, Inc., accessed June 1, 2012, http://www.stealingshare.com/pages/Napoleon%20Strategy%20works.htm.
10. Peggy Duncan, The Time Management Memory Jogger (Salem, NH: Goal/QPC Publishers, 2008), xi.
11. Steven Covey, A. Roger Merrill, and Rebecca R. Merrill, First Things First (New York: Simon and Shuster, 1994), 35.
12. Steven Covey, A. Roger Merrill, and Rebecca R. Merrill, First Things First (New York: Simon and Shuster, 1994), 37
13. James Cooper, “3 Vital Time Management Principles for Small Business Owners & Entrepreneurs,” mimosaPLANET, December 2, 2010, accessed February 4, 2012, http://mimosaplanet.com/Small-Business-Blog/bid/55824/3-Vital-Time-Management-Principles-for-Small-Business-Owners-Entrepreneurs.html.
14. “Activity Logs: Finding Out How You Really Spend Your Time,” Mind Tools, accessed February 4, 2012, http://www.mindtools.com/pages/article/newHTE_03.htm.
15. “5 Time-Management Tricks,” Shifting Careers, December 12, 2007, accessed February 4, 2012, shiftingcareers.blogs.nytimes.com/2007/12/12/5-time-management-tricks.
16. Rachna D. Jain, “10 Ways for Entrepreneurs to Find More Time,” PowerHomeBiz.com, September 9, 2003, accessed February 4, 2012, http://www.powerhomebiz.com/vol124/findtime.htm.
17. Susan Giurleo, “11 Time Management Tips for Small Business Success,” DrSusanGiurleo.com, April 11, 2011, accessed February 4, 2012, drsusangiurleo.com/11-time-management-tips-for-small-business-success.
18. Donald Wetmore, “Some Time Savers,” PowerHomeBiz.com, accessed February 4, 2012, http://www.powerhomebiz.com/vol70/timesavers.htm.
19. Rachna D. Jain, “10 Ways for Entrepreneurs to Find More Time,” PowerHomeBiz.com, September 9, 2003, accessed February 4, 2012, http://www.powerhomebiz.com/vol124/findtime.htm.
20. Susan Giurleo, “11 Time Management Tips for Small Business Success,” DrSusanGiurleo.com, April 11, 2011, accessed February 4, 2012, drsusangiurleo.com/11-time-management-tips-for-small-business-success.
21. Carol Halsey, “The Greatest Technique of Time Management,” PowerHomeBiz.com, accessed February 4, 2012, http://www.powerhomebiz.com/vol94/time.htm.
22. “5 Time-Management Tricks,” Shifting Careers, December 12, 2007, accessed February 4, 2012, shiftingcareers.blogs.nytimes.com/2007/12/12/5-time-management-tricks.
23. “5 Time-Management Tricks,” Shifting Careers, December 12, 2007, accessed February 4, 2012, shiftingcareers.blogs.nytimes.com/2007/12/12/5-time-management-tricks.
24. Susan Giurleo, “11 Time Management Tips for Small Business Success,” DrSusanGiurleo.com, April 11, 2011, accessed February 4, 2012, drsusangiurleo.com/11-time-management-tips-for-small-business-success.
25. “5 Time-Management Tricks,” Shifting Careers, December 12, 2007, accessed February 4, 2012, shiftingcareers.blogs.nytimes.com/2007/12/12/5-time-management-tricks.
26. “5 Time-Management Tricks,” Shifting Careers, December 12, 2007, accessed February 4, 2012, shiftingcareers.blogs.nytimes.com/2007/12/12/5-time-management-tricks.
27. Rachna D. Jain, “10 Ways for Entrepreneurs to Find More Time,” PowerHomeBiz.com, September 9, 2003, accessed February 4, 2012, http://www.powerhomebiz.com/vol124/findtime.htm
28. “10 Time Management Mistakes: Avoiding Common Pitfalls,” Mind Tools, accessed February 4, 2012, http://www.mindtools.com/pages/article/time-management-mistakes .htm.
29. Donald Wetmore, “Some Time Savers,” PowerHomeBiz.com, accessed February 4, 2012, http://www.powerhomebiz.com/vol70/timesavers.htm.
30. “10 Time Management Mistakes: Avoiding Common Pitfalls,” Mind Tools, accessed February 4, 2012, http://www.mindtools.com/pages/article/time-management-mistakes .htm.
31. “20 Quick Tips for Better Time Management,” Stepcase Lifehack, accessed March 12, 2012, http://www.lifehack.org/articles/lifehack/20-quick-tips-for-better-time-management .html#
32. Susan Ward, “11 Time Management Tips: Part 1: Coming to Grips with the Time Management Myth,” About.com, accessed February 4, 2012, sbinfocanada.about.com/cs/timemanagement/a/timemgttips.htm
33. “Efficiency, Organizational,” Mondofacto, December 12, 1998, accessed February 4, 2012, http://www.mondofacto.com/facts/dictionary?efficiency%2C+organizational.
34. “Owen Laughlin Quotes,” Searchquotes, accessed February 4, 2012, http://www.searchquotes.com/quotation/Money_never_starts_an_idea._It_is_always_the _idea_that_starts_the_money/17400.
35. Thomas Friedman and Michael Mandelbaum, That Used to Be Us: How America Fell Behind the World It Invented and How We Can Come Back (New York: Farrar, Straus and Giroux, 2011).
36. Thomas Friedman, Hot, Flat, and Crowded: Why We Need a Green Revolution—and How It Can Renew America (New York: Farrar, Straus and Giroux, 2008)
37. Thomas Friedman, The World Is Flat: A Brief History of the Twenty-First Century (New York: Farrar, Straus and Giroux, 2005).
38. Barry Jaruzelski and Kevin Dehoff, “The Global Innovation 1000: How the Top Innovators Keep Winning,” Strategy+Business (Booz & Company), November 3, 2010, accessed February 4, 2012, http://www.strategy-business.com/article/10408?gko=08375.
39. “W. C. Fields Quotes,” Goodreads, accessed February 4, 2012, http://www.goodreads.com/author/quotes/82951.W_C_Fields.
40. Jeffrey P. Baumgartner, “The Step by-Step Guide to Brainstorming,” The Wonderful World of Jeffery Paul Baumgartner, accessed February 4, 2012, jpb.com/creative/brainstorming.php.
41. “Brainstorming: Generating Many Radical, Creative Ideas,” Mind Tools, accessed February 4, 2012, http://www.mindtools.com/brainstm.html.
42. “William A. Foster—‘Quality Is Never an Accident…,” Quotegasm, accessed February 4, 2012, http://www.quotegasm.com/william-a-foster/william-a-foster-quality-is-never -an-accident.
43. “2010 Award Recipient: K&N Management,” Malcolm Baldrige, accessed February 4, 2012, http://www.baldrige.nist.gov/PDF_files/2010_K&N_Management_Profile.pdf.
44. “2009 Award Recipient: Midway USA,” Malcolm Baldrige, accessed February 4, 2012, http://www.baldrige.nist.gov/PDF_files/MidwayUSA_Profile.pdf.
45. David Garvin, “What Does ‘Product Quality’ Really Mean?,” Sloan Management Review 26, no. 1 (1984): 25–43.
46. A. Parasuraman, Valerie A. Zeithaml, and Leonard L. Berry, “A Conceptual Model of Service Quality and Its Implications for Future Research,” Journal of Marketing 49 (1985): 41.
47. Valerie A. Zeithaml, A. Parasuraman, and Leonard L. Berry, Delivering Quality Service: Balancing Customer Perceptions and Expectations (New York: Free Press, 1990), 38.
48. “Walter A. Shewhart,” ASQ, accessed February 4, 2012, asq.org/about-asq/who -we-are/bio_shewhart.html.
49. Economic Control of Quality of Manufactured Product Walter A. Shewhart, Economic Control of Quality of Manufactured Product (New York: D. Van Nostrand Company, 1931)
50. Statistical Method from the Viewpoint of Quality Control,Walter A. Shewhart, Statistical Method from the Viewpoint of Quality Control (Long Island, NY: Dover Publications, 1980).
51. The Quality Control Handbook.“Joseph M. Juran,” Juran Institute Inc., accessed February 4, 2012, http://www.juran.com/about_juran_institute_our_founder.html.
52. Robert B. Austenfeld Jr., “W. Edwards Deming: The Story of a Truly Remarkable Person,” International Quality Federation, May 10, 2011, accessed February 4, 2012, http://www.iqfnet.org/Ff4203.pdf.
53. “History’s Hidden Turning Points,” Leadership Alliance, accessed March 2, 2012, http://www.leadershipalliance.com/demingnews.htm.
54. Source: W. Edwards Deming, Out of Crisis (Cambridge, MA: MIT Press, 1982), 23–24.
55. Philip Crosby, Quality Is Free (New York: McGraw-Hill, 1979).
56. Philip B. Crosby, “Quality Is Free—If You Understand It,” Philip Crosby Associates II Inc., accessed February 4, 2012, http://www.wppl.org/wphistory/philipcrosby/QualityIsFreeIfYouUnderstandIt.pdf.
57. Walter Lareau, American Samurai: Why Every American Executive Must Fight for Quality (New York: Warner Books, 1991), 47.
58. Wolf Akpose, “A History of Six Sigma,” December 2010, accessed February 4, 2012, http://www.todaysengineer.org/2010/Dec/six-sigma.asp.
59. “Six Sigma Training, History, Definitions: Six Sigma and Quality Management Glossary,” BusinessBalls.com, accessed February 4, 2012, http://www.businessballs.com/sixsigma.htm.
60. Greg Brue, “Six Sigma for Small Business,” Entrepreneur Press, 2006, accessed February 4, 2012, http://www.entrepreneur.com/downloads/assist/six_sigma_for_smallbusiness.pdf.
61. Thomas Edison, “Thomas A Edison Quotes,” Brainy Quote, accessed February 5, 2012, http://www.brainyquote.com/quotes/quotes/t/thomasaed149058.html.
62. Shigeo Shingo, “Lean Quote: A Simple Quote…An Important Idea…,” Matt Hrivnak.com, accessed February 5, 2012, matthrivnak.com/2008/03/19/a -simple-quotean-important-idea.
63. James P. Womack, Daniel T. Jones, and Daniel Roos, The Machine That Changed the World: The Story of Lean Production—Toyota’s Secret Weapon in the Global Car Wars That Is Now Revolutionizing World Industry (New York, Harper Perennial, 1990).
64. Jim Black, “Kaizen (Continuous Improvement) for Small- and Medium-Sized Companies,” CIRAS News 33, no. 2 (1999), accessed February 4, 2012, http://www.ciras.iastate.edu/publications/management/Kaizen.asp.
65. “The Five Principles of Lean Thinking,” Cardiff University, accessed February 4, 2012, http://www.cardiff.ac.uk/lean/principles/index.html.
66. Source: Derived from Value Stream, http://facultyweb.berry.edu/jgrout/processmapping/Value_Stream/value_stream.html
67. “The Principles of Lean Thinking: Tools and Techniques for Advanced Manufacturing,” Industial Technology Centre, accessed February 4, 2012, http://www.itc.mb.ca/downloads/resources_by_topic/princ_lean%20thinking/PrinciplesofLeanThinkingRevD2004.pdf.
68. Michael George, Lean Six Sigma for Service: How to Use Lean Speed and Six Sigma Quality to Improve Services and Transactions (New York: McGraw-Hill, 2003), 76.
69. “Seven Wastes of Service | Customer Perception,” Lean Manufacturing Tools, accessed February 5, 2012, leanmanufacturingtools.org/81/seven-wastes-of-service -customer-perceptio.
70. “5S Check List,” Systems2win, accessed March 9, 2012, http://www.systems2win.com/solutions/5S.htm.
71. Michael George, Lean Six Sigma for Service: How to Use Lean Speed and Six Sigma Quality to Improve Services and Transactions (New York: McGraw-Hill, 2003), 6.
72. “Wanderings: Dave Barry Learned All This in 50 Years,” Brent Zupp, accessed February 6, 2012, http://www.wanderings.net/notebook/Main/ThingsLearn50YearsDaveBarry.
73. Nancy Roman, “Meetings: How to Waste Time at Work,” Cornelius & Associates, accessed June 1, 2012, http://www.corneliusassoc.com/articles/Meetings%20waste%20time.pdf.
74. Roy Woodard, “Meetings, Bloody Meetings,” Credit Control 15, no. 5 (1993): 1.
75. Robert F. Moran Jr., “Meetings: The Bane of the Workplace, It Doesn’t Have to Be,” Library Administration & Management 20, no. 3 (2006): 135–39, accessed February 6, 2012, journals.tdl.org/llm/article/view/1637/917.
76. Judith Lindenberger, “Make the Most of Your Meetings,” Office Solutions 24, no. 3 (2007): 40.
77. Stuart Levine, “Make Meetings Less Ready,” HR Magazine 52, no. 1 (2007): 107.
78. Stuart Levine, “Make Meetings Less Ready,” HR Magazine 52, no. 1 (2007): 107.
79. Charlie Hawkins, “‘F’ Words for Effective Meetings,” Journal for Quality and Participation 22, no. 5 (1999): 56.
80. Roy Woodard, “Meetings, Bloody Meetings,” Credit Control 14, no. 5 (1993): 1.
81. Kelley Robertson, “How to Run an Effective Sales Meeting,” Changing Minds, June 7, 2009, accessed February 4, 2012, changingminds.org/articles/articles09/effective_sales_metting.htm.
82. Stuart Levine, “Make Meetings Less Ready,” HR Magazine 52, no. 1 (2007): 107
83. Jay Boehmer, “Harvard Study Shows Face-to-Face Meeting Value, Rising Virtual Interest,” Successful Meetings, accessed February 6, 2012, http://www.successfulmeetings.com/Event-Planning/Technology-Solutions/Articles/Harvard-Study-Shows-Face-To-Face-Meeting-Value,-Rising-Virtual-Interest.
84. T. L. Stanley, “Make Your Meetings Effective,” SuperVision 67, no. 4 (2005): 6
85. Curt Smith, “Effective Meetings—Not an Oxymoron!” Manage 51, no. 1 (1999): 10
86. Robert F. Moran Jr., “Meetings: The Bane of the Workplace, It Doesn’t Have to Be,” Library Administration & Management 20, no. 3 (2006): 135–39, accessed February 6, 2012, journals.tdl.org/llm/article/view/1637/917.
87. Charlie Hawkins, “‘F’ Words for Effective Meetings,” Journal for Quality and Participation 22, no. 5 (1999): 56
88. Wayne Chaneski, “Productive Meetings—Back to Basics,” Modern Machine Shop 79, no. 11 (2007): 52, accessed February 6, 2012, http://www.mmsonline.com/columns/productive-meetingsback-to-basics.
89. Judith Lindenberger, “Make the Most of Your Meetings,” Office Solutions 24, no. 3 (2006): 40
90. Jim Sullivan, “Focused Agenda Can Energize Manager Meetings,” Nations Restaurant News 37, no. 5 (2003), accessed February 6, 2012, findarticles.com/p/articles/mi_m3190/is_5_37/ai_97392571.
91. Anonymous, “Running Meetings Effectively,” The British Journal for Administration Management, October/November 2005, 25
92. Charlie Hawkins, “‘F’ Words for Effective Meetings,” Journal for Quality and Participation 22, no. 5 (1999): 56
93. Max Messner, “Conducting Effective Meetings,” Strategic Finance 82, no. 12 (2001): 8, accessed February 6, 2012, findarticles.com/p/articles/mi_hb6421/is_12_82/ai_n28842307.
94. Kelley Robertson, “How to Run an Effective Sales Meeting,” Changing Minds, June 7, 2009, accessed February 4, 2012, changingminds.org/articles/articles09/effective_sales_metting.htm.
95. Charlie Hawkins, “‘F’ Words for Effective Meetings,” Journal for Quality and Participation 22, no. 5 (1999): 56
96. Joseph Allen, Steven Regelberg, and John Scott, “Mind Your Meetings,” Quality Progress, April 2008, 42, 4, 51
97. Walter Lippman, “When All Think Alike, Then No One Is Thinking,” Uneven Chopsticks, accessed February 6, 2012, unevenchopsticks.com/when-all-think-alike-then-no-one -is-thinking.
98. Christer Karlsson and Pär Ahlstrom, “A Lean and Smaller Global Firm?,” International Journal of Operations and Production Management 17, no. 10 (1997): 940.
99. Sarah E. Needleman, “Three Best Ways to Get Lean,” Wall Street Journal, March 25, 2000, accessed February 6, 2012, online.wsj.com/article/SB10001424052748704094104575143680597058528.html.
100. Lawrence P. Etkin, Farhard M. E. Raiszadeh, and Harold R. Hunt Jr., “Just-in-Time: A Timely Opportunity for Small Manufacturers,” Industrial Management 32, no. 1 (1990): 16.
101. Matthew Zayko, Douglas Broughman, and Walter Hancock, “Lean Manufacturing Yields World-Class Improvements for Small Manufacturing,” IIE Solutions 29, no. 4 (1997): 36
102. John T. Slania, “Lean Firms Look to Ride Recovery,” Crain’s Chicago Business 27, no. 2 (2004): SB6
103. Mario Emiliani, “Supporting Small Businesses in Their Transition to Lean Production,” Supply Chain Management 5, no. 2 (2000): 66–71
104. Nanchanok Wongsamuth, “Nawaplastic Pushes Lean Management,” McClatchy Tribune Business News, July 31, 2010
105. Matt Dotson and Brandon Kennington, “Eliminating Waste Using Lean Concepts for Small Business,” Automate My Small Business, November 9, 2009, accessed February 4, 2012, automatemysmallbusiness.com/eliminating-waste-using-lean-concepts-for -small-business.
106. Renee O’Farrell, “Problems of Small Scale Industries,” eHow, accessed March 7, 2012, http://www.ehow.com/about_5368391_problems-small-scale-industries.html.
107. Richard Sandusky, “The Problems That Small Business Owners Face,” eHow, accessed March 7, 2012, http://www.ehow.com/list_6521178_problems-small-business-owners-face .html.
108. Rod Kurtz, “Solving Time Management Problems,” BusinessWeek.com, accessed March 7, 2012, http://www.BusinessWeek.com/smallbiz/tips/archives/2007/01/solving_time _management_problems.html.
109. Market Watch: Wall Street Journal, “IBM Launches Global Boot Camps to Help Small and Midsize Businesses Build Social Media Skills,” Wall Street Journal, accessed March 7, 2012.
110. Diane Kulisek, “Top Three Small Business Quality Problems,” CAPAtrak (blog), accessed March 7, 2012, capatrak.wordpress.com/2009/12/21/top-three-small -business-quality-problems. | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.02%3A_Chapter_5-_The_Search_for_Efficiency_and_Effectiveness.txt |
John Bello and Tom Schwalm founded SoBe Beverages in Norwalk, Connecticut, in 1996. The name is an abbreviation of South Beach, the well-known upscale area in Miami, Florida. John describes SoBe as playfully irreverent, having brand equity with meaning, a cult brand that resonates in the marketplace. He attributes the company’s success to some luck, missteps by the competition, being aggressive, and tapping into a cultural shift.
SoBe tapped into a cultural shift toward healthier living and wellness and the rise of companies like General Nutrition that focused on wellness products: vitamins, supplements, minerals, and herbs. Their first product, Black Tea 3G, contained ginseng, guarana, and ginkgo. Orange Carrot, another of SoBe’s first successful products, is a blend of orange and carrot juices enhanced with calcium, chromium picolinate, and carnitine. An extensive line of other flavors was added. All ingredients were linked to specific health benefits.
The first two years of operation saw SoBe losing money, but by the end of 1997, the company was on fire. In five years, the company went from \$0 to \$300 million in sales, and it became a national brand. SoBe was competing effectively at a premium price. Coca-Cola, Pepsi, Arizona, and other brands took notice. Within three years, Coca-Cola was talking to SoBe about a possible strategic partnership. There were fifteen meetings, only two of which were with marketing. The rest were with corporate lawyers (John calls them “sales preventers”) and regulators. At the end of 1999, Minute Maid presented the proposal to the Coca-Cola board. Surprisingly, it was rejected. Coca-Cola saw no reason to go beyond carbonated soft drinks, and there were also some leadership issues. Back to square one.
John and Tom started looking at liquidation because of pressure from investors who wanted their money. But there were other reasons they thought about selling. They were not interested in managing a disparate group of investors—bankers, investors, and private equity companies. With 250 employees, the company was growing into something they did not want it to be—and they were not having as much fun. In 2000, the market was flattening, so with a big brand image, it was a good time to get out. They also wanted to get into larger markets, such as schools and golf clubs, but only big companies could get them into a broader marketplace. They hired an investment bank and again went into negotiations with Coca-Cola as a strategic partner. The situation became very complicated and frustrating. Ultimately, a deal with Coca-Cola was again a no-go.
All was not lost. Pepsi (and others) had expressed an interest. John made a presentation to forty people at Pepsi—rather than the multiple presentations he had to make to Coca-Cola—and within two weeks, they had a deal. SoBe was sold in 2000 to Pepsi for an impressive \$370 million…a very nice return on an investment of \$7 million in cash and \$1 million in trade-out services. Part of the deal was that John would stay on at Pepsi for two years to manage the brand, but after one day, it was clear to him that he was not going to be managing anything. Things were moved into committee, and the corporate bureaucracy took over. John likened the experience to “Making Ho Chi Minh a general in the US Army,” that is, he had a very different way of doing things. He is independent, is unconventional, speaks his mind, and would rather do things and make them work—an approach that tends to be at odds with the culture in large corporations.
SoBe inspired a whole line of functional beverages that people like to buy to make them feel smarter, healthier, and sexier. The company helped to build careers that have lasted. John is very happy with his legacy…and with his piece of the \$370 million sale price.[1]
Most textbooks on small business and entrepreneurship emphasize, quite correctly, the benefits and joys of owning and operating one’s own business. However, they often neglect to cover many of the challenges of continuing to operate a business successfully—the icebergs that can sink a business. The first half of this chapter covers one of the biggest icebergs: a natural or a man-made disaster and the disaster planning that should precede it. Being able to anticipate a disaster will contribute significantly to its effective handling so that a business can survive.
Even if a small business survives a disaster or another kind of iceberg, the owner may still wish to walk away. If a business does not survive, the owner will have no choice but to walk away. There may be other reasons forcing the owner to walk away, or escape, as well. The second half of this chapter discusses the forced escape and the other end of the spectrum—when things go so well that the business owner is ready to move on to another phase of his or her life. In both cases, an exit strategy will be required.
Icebergs
Learning Objectives
1. Understand the kinds of disasters that can face a small business.
2. Understand why disaster planning is important to a small business.
3. Describe the process of disaster planning.
4. Describe the sources of disaster assistance for small businesses.
A natural or a man-made disaster is but the tip of the iceberg. Planning for the complexity of what lies below the tip is important for every small business. Small- to medium-sized businesses are the most vulnerable in the event of a disaster.[2] It has been estimated by the US Department of Labor that 40 percent of businesses never reopen following a disaster. At least 25 percent of the remaining companies will close within two years. The Association of Records Managers and Administrators estimated that over 60 percent of small businesses that experience a major disaster close by the end of two years.[3]
Given these odds, planning for disaster recovery makes great sense—even if, in the end, walking away makes the most sense. If a small business owner decides to rebuild, the process can begin after human health and safety are restored, the electricity is back on, and transportation is up and running. Everyone will want life to return to normal following the destruction, but that may not be possible for every small business. The market may change. Conditions may change, and a business must change to succeed in disaster recovery.[4]
Disaster Planning
In the film Apollo 13, astronauts and engineers went through seemingly endless simulations of what might go wrong on a flight to the moon. The astronauts complained that some of the scenarios were unrealistic and almost impossible to occur. But when a near disaster occurred on Apollo 13, the engineers and astronauts were confronted with a problem that had never been considered; however, because of their prior experience with disaster training, they were able to develop a solution.
Rather than being negative, anticipating what can go wrong can be profoundly positive through either prevention or quickly responding to a crisis. The wise small business owner should appreciate Murphy’s Law (“Anything that can go wrong will go wrong”) and Murphy’s first corollary (“And it will go wrong at the worst possible moment”). The most pragmatic small business owner will also realize that Murphy was an optimist.
The Federal Emergency Management Agency declared 741 natural disasters in the United States for the period 2000 to 2011. Of that number, 66 percent were declared across the following six states: Texas (#1), California, Oklahoma, New York, Florida, and Louisiana (#6). However, every state and territory was represented.[5] Planning for the aftermath of severe storms, flooding (e.g., perhaps snow melts too fast), fire, a hurricane or a tornado, a terrorist attack, or—in some areas—an earthquake is the key to getting back to business with a minimum of disruption. Not all businesses will face the same likelihood of these disasters occurring, but everyone faces the possibility of fire, severe storms, and flooding. Every situation will be unique, with the complexity of issues depending on the particular industry, size, location, and scope of a business.[6] The widespread nature of a the typical disaster means that public services, such as police, fire fighters, and medical assistance, will be unable to reach everyone right away. A business might be going it alone for a while.[7]
According to a recent poll conducted by the National Federation of Independent Business, man-made disasters affect 10 percent of small businesses, and natural disasters have impacted more than 30 percent of all small businesses in the United States.[8]Man-made disasters are disastrous events caused directly and principally by one or more identifiable deliberate or negligent human actions.[9] They include such things as arson, radiation contamination, terrorism, structural collapse due to engineering failures, civil disorder, and industrial hazards.[10] The better prepared a business is, the faster it will be able to recover and resume operations…if that is the decision. Having a disaster plan can mean the difference between being shut down for a few days and going out of business entirely.[11]
A Disaster Planning Success Story
Joe Bogner of Dodge City, Kansas, learned the importance of disaster planning firsthand. He owns Western Beverage, Inc., a beverage distribution company serving twenty-nine counties in western Kansas. In 2002, Western Beverage sustained millions of dollars in fire damage. Yet the company resumed deliveries after just three days. Bogner was named the Kansas City Small Businessperson of the Year for 2006, partially because of his company’s ability to respond to adversity. As his nomination package stated, “Setting up plans of action and following through are Joe’s way of life. He has proven and is continuing to prove that dreams can come true.”[12]
Four key facts about disaster planning must be kept in mind: (1) disasters will occur, (2) an owner must have a plan before the disaster occurs, (3) react with urgency but do not panic, and (4) ride it out.[13] If an owner is committed to having a disaster plan for a business, the plan and process can be structured in a variety of ways. For this section, however, the recommendations on Ready.gov serve as the structure for our discussion. These recommendations reflect the Emergency Preparedness Business Continuity Standard (NFPA 1600) developed by the National Fire Protection Association and endorsed by the American National Standards Institute and the Department of Homeland Security.[14] The recommendations are divided into three areas: plan to stay in business, talk to the people, and protect the investment. The topics discussed here are presented in Figure 6.1 “Disaster Planning”. They have the greatest immediacy for a small business.
Figure 6.1 Disaster Planning [15]
A business owner has invested a tremendous amount of time, money, resources, and emotions into building a business, so he or she will want to be able to survive a natural or man-made disaster. This requires taking a proactive approach so that the chances of the business surviving are increased. Unfortunately, nothing can be done to guarantee the survival of a business because there is no way to know what kind of disaster may occur—or when. There is also no way to know what kind of business environment the owner will face after the disaster. There are, however, several things can be done to increase those chances of survival. Resist the temptation to put emergency planning on the back burner.
Be Informed
It is important to look realistically at the types of disasters that might affect a business internally and externally and prepare a risk assessment. Consider the natural disasters that are most common in the areas where the business operates and think about the business’s vulnerability to man-made disasters. Fires are the most common disasters in the United States, and they are extremely destructive to businesses,[16] but an owner may not be aware that a community is very vulnerable to flooding from snow melt or that the proximity to a chemical plant makes a business vulnerable to the results of explosions. This is why it is important to prepare a risk assessment so that the business can plan accordingly.
Make a Continuity Plan
It is said that a business continuity plan is the least expensive insurance any business can have—especially a small business—because it costs virtually nothing to produce.[17] The better the continuity planning is before a disaster, the greater the chances that a business will survive and recover. There are many things that can be done. The following is not an exhaustive list:
1. Carefully assess how the business functions. Document internal key personnel and backups (i.e., the personnel without whom a business absolutely cannot function). The list should be as large as necessary but as small as possible.
2. Identify suppliers, shippers, resources, and other businesses that are interacted with on a daily basis. Document these and other external contacts, such as bankers, attorneys, information technology (IT) consultants, utilities, and municipal and community offices (police, fire, etc.) that may be needed for assistance.
3. Identify people who can telecommute. Take steps to ensure that critical staff can telecommute if necessary.
4. Plan for payroll continuity.
5. Document critical equipment. Personal computers, fax machines, special printers and scanners, and software are critical to most businesses. An accurate inventory will help a business restore critical equipment.
6. Make sure that all data and critical documents are protected. Critical documents include articles of incorporation and other legal papers, utility bills, banking information, and human resources documents; all these will be required to start over again. The Small Business Administration (SBA) recommends that vital business records—information stored on paper and computer—should be copied and saved at an offsite location at least fifty miles away from the main business site.[20] Companies such as Carbonite can store records “on the cloud.”
7. Identify a contingency location where business can be conducted while the primary office is unavailable. Many hotels have well-equipped business facilities that can be used, but remember that other businesses may need to do the same thing. It is good to have a contingency plan for a contingency location.
8. Put all the information together. The continuity plan is an important document, a copy of which should be given to all key personnel. Do not distribute the plan to people who do not need to have it. The plan will contain sensitive and secure information that could be used by a disgruntled employee for inappropriate purposes.
9. Plan to change the plan. There will always be events that could not have been factored into the plan. For example, the contingency site is damaged beyond use or the business’s bank is in an area that will be without power for days. Situations such as these will require immediate changes to the plan.
10. Review and revise the plan.
Talk to People
Without good communication, the internal and external structure of a business—and its daily operations—will face challenges that may ultimately lead to its downfall.[21] Strong communication skills are, therefore, a vital part of business success. When first starting out, the owner will need good communication skills to attract and keep new customers. As the business grows and new employees are required, these skills will be needed to hire, motivate, and retain good staff.[22] It is for this reason that the employees of a business should play a central role in creating a disaster plan.
Involve Coworkers
Providing for the well-being of all employees is one of the best ways to ensure that a business will recover from a disaster. A business must be able to communicate with them before, during, and after a disaster. There are several recommendations for doing this, including the following:[23]
• Employees from all levels in the organization should be involved.
• Internal communications tools, such as newsletters and intranets, should be used to communicate emergency plans and procedures.
• Set up procedures to warn people, being sure to plan how to warn employees who are hearing impaired, are otherwise disabled, or do not speak English.
• Encourage employees to find an alternate way of getting to and from work in case their usual way of transportation is interrupted.
• Keep a record of employee emergency contact information with other important documents.
Write a Crisis Communication Plan
The owner must decide how the business will contact suppliers, creditors, other employees, local authorities, customers, media, and utility companies during and after the disaster. One easy way to do this is to assign key employees to make designated contacts. Provide a list of these key employees and contacts to each affected employee and keep a copy with other protected contacts. Each key employee should also keep a copy of the list at home. In addition,[24] do the following:
• Make sure that top executives have all the relevant information needed to protect employees, customers, vendors, and nearby facilities.
• Update customers on whether and when products will be received and services rendered.
• Let public officials know what the business is prepared to do to help in the recovery effort.
• Let public officials know whether the business will need emergency assistance to conduct essential business activity.
Support Employee Health—and the Owner’s Health
Disasters often result in business disorientation and environmental detachment, with the psychological trauma of key decision makers leading to company inflexibility (perhaps inability) to deal with the change required to move forward.[25] If the owner or other key personnel experience post traumatic stress disorder, it can cripple a business’s decision-making ability.
No matter the disaster, there will be psychological effects (e.g., fear, stress, depression, anxiety, and difficulty in making decisions) as well as—depending on the nature of the disaster—physical effects such as injuries, burns, exposure to toxins, and prolonged pain.[26] As a result, the owner and the employees may have special recovery needs. To support those needs, do the following:[27]
• Provide for time at home to care for family needs, if necessary.
• Have an open-door policy that facilitates seeking care when needed.
• Reestablish routines as best as possible.
• Offer special counselors to help people address their fears and anxieties.
• Take care of yourself. Leaders tend to experience increased stress after a disaster. The leader’s own health and recovery are also important to both family and the business as a whole.
Protect the Investment
Last but certainly not least, take steps to protect the business and secure its physical assets. Among the things that can be done, having appropriate insurance coverage; securing facilities, buildings, and plants; and improving cybersecurity are at the top of the list.
Insurance Coverage
Having inadequate insurance coverage can leave a business vulnerable to a major financial loss if it is damaged, destroyed, or simply interrupted for a period of time. Because insurance policies vary, meet with an insurance agent who understands the needs of a particular business.[28]
• Review coverage for things such as physical losses, flood coverage, and business interruption. Normal hazard insurance does not cover floods, so make sure the business has the right insurance.[29]Business interruption insurance protects a business in the event of a natural disaster, a fire, or other extenuating circumstances that affect the ability of a company to conduct business.[30] Small business owners should seriously consider this type of insurance because it can provide enough money to meet overhead and other expenses while out of commission. The premiums for these policies are based on a company’s income.[31]
• Understand what the insurance policy covers and what it does not cover.
• Add coverage as necessary.
• Understand the deductible and make adjustments as appropriate.
• Think about how creditors and employees will be paid.
• Plan how to pay yourself if the business is interrupted.
• Find out what records the insurance provider will require after an emergency and store them in a safe place. It would be a good idea to take pictures of your physical facilities, equipment, buildings, and plant so that insurance claims can be processed quickly. These pictures will also provide a good basis for putting the operation back into working order.
Secure Facilities, Buildings, and Plants
One cannot predict what will happen in the case of a disaster, but there are steps that can be taken in advance to help protect a business’s physical assets, including the following:[32]
• Fire extinguishers and smoke detectors should be installed in appropriate places.
• Building and site maps with critical utility and emergency routes clearly marked should be available in multiple locations—and they should be protected with other important documents.
• Think about whether automatic fire sprinklers, alarm systems, closed circuit television, access control, security guards, or other security measures would make sense.
• Secure the entrance and the exit for people, products, supplies, and anything else that comes into and leaves the business.
• Teach employees to quickly identify suspect packages and letters, for example, packages and letters with misspelled words, no return address, the excessive use of tape, and strange coloration or odor. Have a plan for how such packages and letters are to be handled.
Improve Cybersecurity
Many, perhaps most, small businesses will have data and IT systems that may require specialized expertise. They need to be protected. The industry, size, and scope of a business will determine the complexity of cybersecurity, but even the smallest business can be better prepared.[33] Small businesses are the most vulnerable to cybersecurity breaches because they have the weakest security systems, thereby making them easier online targets.[34]
Video Clip 6.1- Cybersecurity
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=64
An overview of cybersecurity.
Video Link 6.1- Chubb Group of Insurance Companies
The Chubb Group of Insurance Companies provides a very good video discussion of cybersecurity.
www.chubb.com/businesses/csi/chubb822.html
Every computer can be vulnerable to attack. The consequences can range from simple inconvenience to financial catastrophe.[35] There are several things that can be done to protect a business, its customers, and its vendors, including the following:
• Explore cybersecurity liability insurance. This coverage is available at reasonable rates to protect against credit card identity theft, with limits up to \$5 million. This insurance will cover the loss of digital assets plus expenses for public relations, damages, and service interruption. It will also protect customers. The notification of customers whose credit was compromised is included plus any legal costs and a year of credit monitoring for each individual affected. Although other cybersecurity insurance policies can cover data loss, applicants must break down loss estimates on an hourly basis because most breaches are resolved in hours, not days. This is not an easy thing to do.
• Use antivirus software and keep it up to date. If an owner is not already doing this, he or she should probably have a mental examination.
• Do not open e-mail from unknown sources. Always be suspicious of unexpected e-mails that include attachments, whether or not they are from a known source. When in doubt, delete the file and the attachment—and then empty the computer’s deleted items file. This should be a procedure that all employees know about and follow. The owner must do it as well.
• Use hard-to-guess passwords. An application for cyberinsurance requires, among other things, answering the following question: “Are passwords required to be at least seven characters in length, alphanumeric, and free of consecutive characters?” (Check yes or no.) Whether or not a business plans to apply for cyberinsurance, instituting this kind of password policy is well worth consideration.
Key Takeaways
• Small- to medium-sized businesses are the most vulnerable in the event of a disaster.
• Some estimates claim that over 60 percent of small businesses that experience a major disaster close by the end of the second year.
• Planning for disaster recovery makes great sense for protecting a business.
• Every state and territory has experienced disasters. Planning for the aftermath is the key to getting back to business with a minimum of disruption. However, every situation will be unique.
• Man-made disasters affect 10 percent of small businesses, while natural disasters have impacted more than 30 percent of all small businesses in the United States.
• A man-made disaster is a disastrous event caused directly and principally by one or more identifiable deliberate or negligent human actions—for example, arson, terrorism, and structural collapse.
• The better prepared a business is, the faster it will recover from a disaster and resume operations. Having a disaster plan can mean the difference between being shut down for a few days and going out of business entirely.
• Even the smallest business should have a disaster plan.
• The three main areas that an owner should focus on in a disaster plan are the plan to stay in business, talk to people, and protect the investment.
Exercises
Frank’s BarBeQue just missed being impacted by a tornado that ripped through southwestern Connecticut. Many small businesses were lost, never to reopen, while others sustained major physical and economic damage. Frank’s son, Robert, asked his father about whether he was prepared for something like that. Frank’s response was troubling. Although he kept some important documents in a safety deposit box at the bank, there was little planning or protection. Robert explained the importance of disaster planning, but Frank was overwhelmed by the prospect of the process.
Robert contacted a local university and arranged with its school of business for a team of five students to prepare a disaster plan for Frank’s BarBeQue. He presented the project idea to his father and was relieved that his dad was willing to participate. It was clearly understood that no proprietary or confidential information would be shared with the students.
1. Assume that you are the leader of the team. Describe the approach you will take and the recommendations that you will make. It is expected that you will go beyond the information provided in the text. Creativity is strongly encouraged.
Disaster Assistance
Learning Objectives
1. Learn about the sources of disaster assistance for the physical and/or economic losses of small business.
Do not assume that all small businesses will qualify for disaster loan assistance or that insurance will cover the costs of all losses. A small business owner may have to depend on other forms of financial assistance—for example, savings, friends, and family.[39] However, if a small business has sustained economic injury after a disaster, it may be eligible for financial assistance from the Small Business Administration (SBA). If a business is located in a declared disaster area, the owner may apply for a long-term, low-interest loan to repair or replace damaged property.[40]
Physical and Economic Injury Disaster Loans
In the case of a physical disaster, a small business owner may apply for a low-interest SBA loan of up to \$2 million to repair or replace damaged real estate, equipment, inventory, and fixtures: “The loan may be increased by as much as 20 percent of the total amount of disaster damage to real estate and/or leasehold improvements, as verified by SBA, to protect property against future disasters of the same type. These loans will cover uninsured and or under-insured losses.”[41] It is also possible that small business disaster relief loans may be available at the local, county, regional, or state level.[42]
The SBA can also help small businesses that were not damaged physically but have suffered economically.[43] An Economic Injury Disaster Loan of up to \$2 million can be granted to meet necessary financial obligations—expenses the business would have paid if the disaster had not occurred.
The interest rate on both Physical and Economic Injury Disaster Loans will not exceed 4 percent if you do not have credit available elsewhere. Repayment can be up to 30 years, but this will depend on the business’s ability to repay the loan. For businesses that may have credit available elsewhere, the interest rate will not exceed 8 percent. SBA determines whether the applicant has credit available elsewhere.[44]
Disaster Assistance from the Internal Revenue Service
The Internal Revenue Service (IRS) provides some disaster assistance and emergency relief for businesses through special tax law provisions, especially when the federal government declares their location to be a major disaster area. The IRS may grant additional time to file returns and pay taxes. While doing disaster planning, check the latest special tax law provisions that may help a business recover financially from the impact of a major disaster.It would also be a good idea to check out what kind of record keeping the IRS requires so that a business will be fully prepared should it be necessary to take advantage of what the IRS offers.
SCORE Business Advice
Disaster recovery will push the limits of a small business…and then some. Locate the closest offices of SCORE (Service Corps of Retired Executives)—a nonprofit association dedicated to educating entrepreneurs and helping small businesses start, grow, and succeed nationwide—and enlist their support. SCORE provides confidential business counseling services at no charge.[46]
Online Disaster Assistance
DisasterAssistance.gov is a one-stop web portal, self-described as access to disaster help and resources, that details over sixty different forms of assistance from seventeen US government agencies where a business owner can apply for SBA loans through online applications, receive referral information on forms of assistance that do not have online applications, or check the progress and status of online applications.
Benefits.gov wants to let survivors and disaster relief workers know about the many disaster relief programs that are available. There are questions for a small business owner who has suffered damage because of a natural disaster to answer to find out which government benefits the business may be eligible to receive. The site also provides a link to DisasterAssistance.gov
Key Takeaways
• Do not assume that a small business will qualify for disaster loan assistance or that insurance will cover the costs of all losses. A small business owner may have to depend on others for financial assistance—for example, friends, family, and savings.
• A small business owner may apply for a low-interest SBA loan of up to \$2 million to repair or replace damaged real estate. The interest rate on this loan will not exceed 4 percent if credit is not available elsewhere.
• The SBA also provides financial assistance to small businesses that were not damaged physically but suffered economic losses. The interest rate on this loan will also not exceed 4 percent if the business does not have credit available elsewhere.
• The IRS provides disaster assistance and emergency relief through special tax provisions.
• It would be worthwhile checking out SCORE for assistance.
• Online disaster assistance is available through two website portals: DisasterAssistance.gov and Benefits.gov.
Exercises
1. As part of the disaster management plan, Robert has asked the student team to prepare a specific plan for obtaining disaster assistance under the assumption that both physical and economic damages will occur. Review the various options and the material from the previous section in this chapter and then make specific recommendations. It is expected that you will go beyond the information presented in the text.
Escapes: Getting Out of the Business
Learning Objectives
1. Identify the situations in which an owner may choose to get out of business.
2. Identify and understand the situations that may lead to being forced out of business.
3. Understand the resources that can help an owner make a decision.
There are many reasons why an owner might want to walk away from a business; the choice is oftentimes the owner’s. Perhaps the owner wants to sell the business before retirement. Perhaps someone has approached the owner with a terrific offer. Perhaps investors are pressuring the owner for their money. Perhaps no one in the owner’s family wants to take over the business. Perhaps it is no longer fun; the entrepreneurial spirit is gone, and the owner’s passion has changed. It could be that either the owner or the team is not committed to making things work.[51] Perhaps the owner would like to cash out the equity built in the business. There are many other reasons as well:
• The owner is spending more time fixing nominal problems, it feels as if he or she is working backward, and no end seems in sight.
• Instead of being the most optimistic person on the team, the owner starts taking a negative view on most of the decisions the team is making about future prospects for growth.
• Continuing with the business may have serious, lasting personal repercussions, such as threatening one’s marriage, familial relationships, or health. The potential risk is no longer worth the reward.
• The owner sees the writing on the wall: no repeat or referral customers, no positive feedback from any source, or no demand for the business’s product or service. Positive feedback can take many forms: word of mouth, referrals, favorable press, favorable posts and reviews on Facebook and Twitter, and plenty of inquiries. If a business owner is not satisfying customers and attracting new ones, why be in business at all?
When Walking Away Is Not the Owner’s Choice
There will also be those times when walking away from a business may not be the owner’s choice.
• The owner wants no one else to run the business and is unwilling to give up equity. Every small business founder faces the founder’s dilemma—that is, the dilemma between making money and controlling the business.[54] It is tough to do both because they tend to be incompatible goals. Founders often make decisions that conflict with maximizing wealth.[55] If an owner wants to make a lot of money from a business, the owner will need to give up more equity(the money put into the business) to attract investors, which requires relinquishing control as equity is given away; investors may alter the board membership of a business.[56] To retain control of a business, the owner will have to keep more equity, relying on his or her own capital instead of taking money from investors. The result will be less capital to increase a company’s value, but he or she will be able to run the company.[57]
• The owner is facing bankruptcy. One study, [60] found that firms with less sophisticated owners or managers with respect to experience and training increases the likelihood of bankruptcy as do a deteriorating market and having less access to capital. There can be other reasons as well—for example, employee theft, fraud, or a consumer liability lawsuit that drains a company’s assets.
• The owner may be the cause. The owner could be killing the company or, at the very least, shooting himself or herself in the foot. There are several ways in which this could happen: [61] (1) micromanaging, which may lead to, for example, employees presenting problems or issues but no solutions, unusually high turnover, and never receiving a project that the owner does not change; (2) spending money in the wrong places—for example, spending money on items not needed, such as a fancier location, hiring more staff than needed, and attending costly trade shows with limited or no return on investment; (3) chasing after every customer instead of focusing on the ideal and regular customers that should be reached; (4) the owner is not on top of the numbers, perhaps because he or she is not financially minded and has not taken the time to become financially minded or hire someone as the finance person; and (5) the owner is not a people person, perhaps being a “my way or the highway” kind of person who invests no emotion or warmth when dealing with employees and colleagues, or is an egomaniac.
• The owner is seriously ill. Being ill will raise doubts about a company’s future, and new businesses are the most vulnerable.[62] If there is no one in the owner’s family who is interested in or willing to take over the business, this can add additional stress to the situation.
• The industry dies or implodes. Sometimes the demand for a service or a product just dies—for example, web-consulting companies during the dot-com bust in 2000 and 2001.[63] Henrybuilt Corporation, a Seattle firm that specialized in designing kitchens from \$30,000 to \$100,000, saw its sales come to a standstill in 2008. Everyone was cancelling projects. The company modified its product and was able to survive.[64]
Resources to Help Make a Decision
The decision to walk away from a business—whether that decision is voluntary or forced—is not an easy one to make. Consult with an appropriate mix of individuals; a partner or partners if applicable, your spouse, your family, an attorney, an accountant, and perhaps someone from SCORE. Each individual can offer a different perspective and different counsel. Ultimately, however, the decision is the owner’s.
One thing is for certain. Whether the escape is voluntary or forced, there should be an exit strategy.
Key Takeaways
• Escaping from a business is the owner’s choice when, for example, he or she wants to sell the business before retirement, someone has approached the owner with a terrific offer, investors are pressuring the owner for their money, no family member wants to take over the business, or it is not fun anymore.
• An escape may be forced when, for example, an owner wants no one else to run the business and is unwilling to give up equity or is facing bankruptcy or is seriously ill.
• The owner should consult with a mix of resources before making a decision.
Exercises
1. You are the twenty-eight-year-old founder of a very successful, five-year-old software company. For the last three years, sales have doubled in each year. Last year’s sales were \$75 million. A major high-tech firm wants to buy your company. They will offer cash and will sweeten the offer by allowing you the option of being CEO for at least two years. How much would the firm have to offer you to take this deal? How would you know if it was a fair offer? Would you exercise the option to act as CEO for the two years? If you took the offer, what would be your life plans?
Exit Strategies
Learning Objectives
1. Understand the importance of an exit strategy.
2. Explain the exit strategies that a small business can consider.
The most emotional topic a small business owner will face while building a business—and the hardest decision to make—is when and how to exit the business. This very personal decision should be considered while building the business because this decision will impact many other decisions made along the way.[65] Ultimately, however, an exit strategy must be developed whether or not it is considered along the way. The strategy should be developed early in the business, and it should be reviewed and changed periodically because conditions change. Unfortunately, many small business owners have no exit strategy. This will make an already very emotional decision and process even more difficult.
There are many exit strategies that a small business owner can consider. Liquidation or walk away, family succession, selling the business, bankruptcy, and taking the company public are discussed here. Selecting an exit strategy is important because the way in which an owner exits can affect the following:[66]
• The value that the owner and/or shareholders (if any) can realize from a business
• Whether a cash deal, deferred payments, or staged payments are received
• The future success of the business and its products or services (unless one is closing the business)
• Whether the owner wants to retain any involvement in or control of the business
• Tax liabilities
Figure 6.4 Possible Exit Strategies
The best exit strategy (see Figure 6.4 “Possible Exit Strategies”) is the one that is the best match to a small business and the owner’s personal and professional goals. The owner must first decide what he or she wants to walk away with—for example, money, management control, or intellectual property. If interested only in money, selling the business on the open market or to another business may be the best choice. If, on the other hand, one’s legacy and seeing the small business continue are important, family succession or selling the business to the employees might be a better solution.[67]
Liquidation or Walkaway
There are times when a small business owner may decide that enough is enough, so he or she simply calls it quits, closes the business doors, and calls it a day.[68] This happens all the time, to hundreds of businesses every day—for example, a small shop, a restaurant, a small construction company, a shoe store, a gift shop, a consignment shop, a nail salon, a bakery, or a video store.This closing of the business involves liquidation, the selling of all assets. If all debts are paid, it can also be referred to as a walkaway.
To make any money with the liquidation exit strategy, a business must have valuable assets to sell—for example, land or expensive equipment. The name of the business may have some value, so it could be purchased by someone for pennies on the dollar and restarted with different owners. There is also a possibility that there may be a substantial amount of goodwill or even badwill if a business has been around for a long time. Goodwill is an intangible asset that reflects the value of intangible assets, such as a strong brand name, good customer relationships, good employee relationships, patents, intellectual property, size and quality of the customer list, and market penetration.[70] However, if a business is simply closed, the value of the goodwill will drop, and the selling price will be lower than it would have been prior to the business being closed.[71]
Badwill is the negative effect felt by a company when it is found out that a company has done something not in accord with good business practices. Although badwill is typically not expressed in a dollar amount, it can result in such things as decreased revenue; the loss of clients, customers, and suppliers; the loss of market share; the loss of credit; federal or state indictments for crimes committed, and censure by the community.[72] For the small business owner who wants to close under these circumstances, there will be nothing much to sell but tangible assets because the business will have very little, if any, market value.
In all instances of liquidation, the proceeds from the sale of assets must first be used to repay creditors. The remaining money is divided among the shareholders (if any), the partners (if any), and the owner.[73] In an ideal walkaway situation, the following occurs:[74]
• All bills are paid off (or scheduled).
• All taxes are paid, and the various levels of government are informed of the closure.
• Contracts, leases, and the like are fulfilled or formally terminated.
• Employees are let go to find other jobs.
• Assets or inventory is depleted.
• No lawsuits are consuming money and time.
• Customers are placed so that they get needed goods or services.
• If needed, insurance is continued to cover unexpected claims after the firm closes.
The walkaway is the cleanest and best way to exit, but it is not always possible for all businesses that decide to close their doors. There will, of course, always be those instances in which the owner closes the business and takes off, leaving a mess behind.
Any small business owner thinking about liquidation should consider the pros and cons, which are as follows:
• Pros
• It is easy and natural. Everything comes to an end.
• No negotiations are involved.
• There are no worries about the transfer of control.
• Cons
• Get real! It is a waste. At most, the owner will get the market value of the company’s assets.
• Things such as client lists, the owner’s reputation, and business relationships may be very valuable. Liquidation destroys them without an opportunity to recover their value.
• Other shareholders, if any, may be less than thrilled about how much is left on the table.
• If a company’s brand has any value, there is a loyal or sizeable customer base, or there is a stable core of employees, an owner would be significantly better off selling the company.
Family Succession
Many small business owners dream of passing the business to a family member. Keeping the business in the family allows the owner’s legacy to live on, which is clearly an attractive option. Family succession as an exit strategy also allows the owner an opportunity to groom the successor; the owner might even retain some influence and involvement in the business if desired.[77] However, given that very few family firms survive beyond the first generation and even fewer survive into the third generation. Succession is the most critical issue facing family firms.[81] Succession is the transference of leadership from one generation to the next to ensure continuity of family ownership of the business.[82]
A sudden decision to hand over the business to a family member is unwise. The owner will be burdened with problems that will likely lead to business failure. Succession in family firms is a multistage, complex process that should begin even before the heirs enter the business, and effects extend beyond the point in time when they are named as successors. Many factors are involved, and the succession should evolve over a long period of time. Further, because succession is usually followed by changes in the organization, particularly the change in the top position, it is thought to be an indicator of the future of the business. The better prepared and committed the successor is, the greater the likelihood of a successful succession process and business.[85] The quality of interpersonal relationships, successors’ expectations, and the role of the predecessor are also relevant to success.[86]
The ideal is for the family business to have engaged in formal succession planning: planning for the family business to be transferred to a family member or members. The failure to plan for succession is seen as a fundamental human resource problem as well as the primary cause for the poor survival rate of family businesses.[87] Unfortunately, a very small percentage of family businesses plan appropriately for succession, and those that do frequently have mental, not written, plans.[88]
Video Clip 6.2- Family Business Succession
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=64
Tarzan Zerbini Circus
Bankruptcy
Feeling the need to file for bankruptcy is a tough pill for any small business owner to swallow. Bankruptcy is an extreme form of business termination that uses a legal method for closing a business and paying off creditors when the business is failing and the debts are substantially greater than the assets.[89] Because bankruptcy is a complicated legal process, it is important to get an attorney involved as soon as possible. There may be options other than bankruptcy, and consulting with an attorney will help. The owner must understand how bankruptcy works and the options that are available. It is also good to know that not all bankruptcies are voluntary; creditors can petition the court for a business to declare bankruptcy.[90]
Chapter 7 small business bankruptcy, more commonly referred to as liquidation, is appropriate when a business is failing, has no future, and has no substantial assets. This form of bankruptcy makes sense only if the owner wants to walk away. It is particularly suited to sole proprietorships and other small businesses in which the business is essentially an extension of its owner’s skills.[91][92]Under Chapter 7 bankruptcy law, a trustee will take a business apart, selling assets to satisfy outstanding debts and discharging debts that cannot be satisfied with the assets that are available.
Small business bankruptcy allows an owner to run a business with court oversight. The owner loses control of the firm, but it continues to operate. The owner is protected from creditors in the short term because the court orders an automatic stay that prevents the creditors from seizing your assets. Unfortunately, the outcome is not pleasant. The owner is out as manager, and the creditors end up owning the business. If the owner cannot pay the \$75,000+ in legal fees, the judge will probably order liquidation.[95] This form of bankruptcy applies to sole proprietorships, corporations, and partnerships.[96]
The amount that creditors can collect will depend on how a business is structured. If a business is a sole proprietorship, the owner’s personal assets may be used to pay off business debts, depending on the chosen bankruptcy option. If a business is a corporation, a limited liability company, or some form of a partnership, the owner’s personal assets are protected and cannot be used to pay off business debts.[97]
Alternatives to Bankruptcy
Instead of going the bankruptcy route, a small business owner could do the following things: [98] This is also known as a Consumer Proposal within Canada.
• Negotiate debt. This involves trying to reorganize a business’s finances outside a legal proceeding. The owner can work with the creditors to renegotiate the terms of payment and the amount owed to each creditor. If a business is basically profitable but the debt situation is due to an unusual circumstance, such as a lawsuit or a temporary industry slowdown, this could be a successful solution.
• Improve operations. If the owner is in a position to fix the cash problem by fixing the underlying problems in the business, it may not be necessary to declare bankruptcy. An owner should look at cash-flow controls; eliminate unprofitable products, services, and divisions; and restructure into a leaner and meaner organization.
• Turn around and restructure the business. This alternative combines debt negotiation and operational improvement—perhaps the best choice. By doing both things at the same time, an owner will be in an even stronger position to improve the balance sheet, cash flow, and profitability—and avoid insolvency.
Taking a Company Public
An initial public offering (IPO) is a stock offering in which the owner or owners of equity in a formerly private company have their private holdings transferred into issues tradable in public markets, such as the New York Stock Exchange (NYSE).[99] From the initial owners’ perspective, an IPO is often seen as liquidation, but it is also a money event for a company. For this reason, an IPO makes sense only if a small business can benefit from a substantial infusion of cash. [100]
IPOs receive lots of press, even though they are really very rare. In a typical year, there may be 200 IPOs, perhaps even less. Consider the following data:
• 2008: 32 IPOs
• 2009: 63 IPOs
• 2010: 157 IPOs
• 2011: 159 IPOs
Why are the numbers so small? [105] The IPO process is costly, labor intensive, and usually requires an up-front investment of more than \$100,000. Detailed reports are required on a business’s financials, staffing, marketing, operations, management, and so forth. Preparing these reports typically costs hundreds of thousands of dollars, sometimes millions, every year. The Sarbanes-Oxley Act alone, a product of the Enron scandal, costs even the smallest companies several hundred thousands of dollars in consulting fees. Lastly, many companies are not valued very highly on the stock market.
When thinking about an IPO, consider the following pros and cons: [106]
• Pros
• The owner will be on the cover of Newsweek.
• The stock will be worth in the tens—or even hundreds—of millions of dollars.
• Venture capitalists will finally stop bugging the owner as they frantically try to ensure their shares will retain value.
• Cons
• Only a very few number of small businesses actually have this option available to them because there are so few IPOs in the United States each year.
• A business needs financial and accounting rigor from day one that is way beyond what many small business owners put in place.
• The owner will spend most of his or her time selling the company, not running it.
• Investment bankers take 6 percent off the top, and the transaction costs of an IPO can run into the millions.
Stever Robbins of Entrepreneur paints an amusing but very dismal picture of what is actually involved in an IPO.[107]
You start by spending millions just preparing for the road show, where you grovel to convince investors your stock should be worth as much as possible…Unlike an acquisition, where you craft a good fit with a single suitor, here you are romancing hundreds of Wall Street analysts. If the romance fails, you’ve blown millions. And if you succeed, you end up married to the analysts. You call that a life? Once public, you bow and scrape to the analysts. These earnest 28-year-olds—who haven’t produced anything of value since winning their fifth grade limerick contest—will study your every move, soberly declaring your utter incompetence at running the business you’ve built over decades. It’s one thing to receive this treatment from your loving spouse. It’s quite another to receive it from Smith Barney. We won’t even talk about the need to conform to Sarbanes-Oxley, or the 6 percent underwriting fees you’ll pay to investment bankers, or lockout periods, or how markets can tank your wealth despite having a healthy business, or how IPO-raised funds distort your income statement, or… In short, IPOs are not only rare, they’re a pain in the backside. They make the headlines in the very, very rare cases that they produce 20-year-old billionaires. But when you’re founding [and running] your company, consider them just one of many exit strategies. Realize that there are a lot of ways to skin a cat, and just as many ways to get value out of your company. Think ahead, surely, but do it with sanity and gravitas. And if you find yourself tempted to start looking for more office space in preparation for your IPO in 18 months, call me first. I’ll talk you down until the paramedic arrives.
For some small businesses, although not many, an IPO might make sense—and may even be necessary. For most, however, an IPO is clearly not a viable exit strategy.
Selling the Business
Another possible exit strategy is selling the business. Although the sale of a business is sometimes described as the end of entrepreneurship or as failure or defeat,[108] selling the business can also be a relief and the beginning of the next phase of the owner’s personal and professional life. As in the case of SoBe (highlighted at the beginning of this chapter), the owners sold the business because, among other things, it was becoming something they did not want it to be—and it was no longer fun. Whatever the reason, an owner can sell a business only once, so be sure that it is the right exit strategy. The owner should address the following questions:
1. Can the business be sold? There are many things that make a business attractive to buyers: a solid history of profitability, a large and loyal base of customers, a good reputation, a competitive advantage (e.g., intellectual property rights, patents, long-term contracts with clients, and exclusive distributorships), opportunities for growth, a desirable location, a skilled workforce, and a loyal workforce. If a business does not have at least some of these things or others of equal value, it will not likely generate much interest in the market.
2. Is the owner ready to sell or does the owner need to sell? Selling a business, when it is a choice, requires emotional and financial readiness. The owner must think about what life will be like after the business is sold. What will be a source of income? How will time be spent? Has the owner “sold out” or could more have been done with the business? Does the owner love what he or she is doing? Many small business owners suffer real remorse after handing their businesses over to a new owner. Selling the business because the owner is forced to will engender very different emotional and financial challenges.
3. What is the business worth? The owner may have no idea. For example, the owner of a small professional services firm felt the firm was worth more than \$1 million. After a lengthy search, however, the owner received less than one-half that amount from the buyer. On the other side of the coin, the owner of an information technology (IT) company planned to sell the company to an employee for \$200,000. However, after advertising the business for sale nationwide, the owner sold it for one dollar shy of \$1 million.
It is recommended that an owner start planning for a sale at least three to four years in advance. Sometimes, even five years is not long enough. It is very easy to become overly attached to a business, so it will be difficult to see how the business really looks to an outsider.[111] Selling a business is an art and a science. If the asking price is too high, this may signal to potential buyers that the owner is not really interested in selling. Because there are several methods used to value a business, it is a good idea to hire a professional.[112]
There are different ways to sell a business (see Figure 6.5 “Four Ways to Sell a Small Business”). Acquisition, friendly buyout, selling to the employees, and selling on the open market are discussed here. Be aware, however, that if a business is floundering and it is well known that the business is having major problems paying bills, vulture capitalists, might start circling. A vulture capitalist is a venture capitalist who invests in floundering firms in the hope that they will turn around. A venture capitalist is an investor who either provides capital to start-up ventures or supports small companies to expand but does not have access to public funding. Venture capitalists typically expect higher returns because they are taking additional risks.[115]
Acquisition
When one business buys another business, as in the case of Pepsi buying SoBe, it is called an acquisition. Businesses buy other businesses for all kinds of reasons—for example, as a quick path to expansion or diversification or to get rid of the competition. When Pepsi was considering acquiring SoBe, their first thought was to kill the brand. But the bottlers convinced them otherwise, saying that it was a very strong brand.[116]
Acquisition is one of the most common exit strategies for a small business. One key to success is to target the potential acquirer(s) in advance, position the business accordingly, and convince the acquirer that the small business is worth the asking price.[117] Another way to become the target of an acquisition is to be successful in the marketplace. This happened with SoBe. Coca-Cola, Pepsi, Arizona, and Campbell’s all expressed an interest after SoBe became a national brand. Pepsi ended up being the acquirer in the end.[118]
In an acquisition, the owner negotiates the price—a good thing because public markets value a business relative to its industry, which limits the value of a business. In an acquisition, however, there is no limit on the perceived value of a company. Why? The person making the acquisition decision is rarely the owner of the acquiring company, so there is no problem with the checkbook. It is someone else’s money.
When thinking about an acquisition, consider the following pros and cons:
• Pros –
• If a business has strategic value to an acquirer, it may pay far more than the business is worth to anyone else.
• If multiple acquirers are in a bidding war, the owner can raise the price “to the stratosphere.”
• Cons –
• If the owner organizes the business around a specific acquirer, the business may be unattractive to other buyers.
• Acquisitions are messy and often difficult when cultures and systems clash in the merged company. Although not a small business example, the Warner-AOL combination was a failure largely due to a major culture clash.
• Acquisitions are frequently accompanied by noncompete agreements and other strings that, while making the owner rich, can make life unpleasant for a while. Noncompete agreements are enforceable, but their enforcement depends on the applicable facts and circumstances—including which state’s law governs.[121]
Friendly Buyout
A friendly buyout occurs when ownership is transferred to family members, customers, employees, current managers, children, or friends. It is still considered selling the business, but the terms and nature of the transaction are usually very different. No matter who the “friendly” buyer may be, figure on starting to plan early—and engage a professional before, during, and after the sale.
When thinking about friendly buyout, consider the following pros and cons:
• Pros –
• The owner knows much more about the buyer, and the buyer knows the owner. There is less due diligence required.
• The buyer will most likely preserve what is important about the business.
• If management buys the business, it has a commitment to make it work.
• Cons –
• The owner will be less objective about the buyer and more likely to let his or her guard down in negotiations and planning. The owner leaves too much money on the table.
• If the owner sells to a friend, the friend will be less than thrilled when discovering, for example, decades’ worth of unpaid taxes.
• Selling to family can tear a company apart with jealousies and promotions that put emotion ahead of business needs.
Selling to Employees
Selling the business to employees and/or managers is another option to consider. “Arranging an employee buyout can be a win-win situation as they get an established business they know a great deal about already and you get enthusiastic buyers that want to see your business continue to thrive.”[128] The owner can accomplish this process by setting up an employee stock option plan (ESOP). However, because the owner is giving control of the business to the employees, a transition plan is critical to make sure that they are ready to carry on the business after the owner leaves. It is a good idea to hire an ESOP specialist. Keep in mind, though, that only corporations are eligible to form an ESOP. An ESOP is expensive to set up and maintain, so this might not be the best choice.[129]
If an ESOP is not appealing or the business is not eligible to have an ESOP, selling the business could be as simple as having a current employee take it over. The owner could also consider a worker-owned cooperative, in which interested employees become members of a cooperative that buys the business.[130] In the case of Select Machine of Brimfield, Ohio, “[the owners] sold 30 percent of their stock to the co-op in the first of several installments. The co-op took out loans in the amount of \$324,000, which were personally guaranteed by the sellers. The loans were paid off out of company profits over three years; subsequent installments have been owner-financed. Today the co-op owns 59 percent of the company’s stock, and sale of an additional 10 percent is now on the table.”[131]
For a worker-owned cooperative to work, the business owner(s) must be totally committed to the sale of the business to the employees. It is a good option if the business is small (fewer than twenty-five employees), profitable, relatively debt free, already has a culture of participatory management, and the owners are willing to stay on throughout the transition.[132]
Selling on the Open Market
Selling a business on the open market is the most popular exit strategy for small businesses.[133] Unfortunately, it has been estimated that 75 percent of US businesses do not sell,[134] so if this is how the owner wants to sell the business, it must be marketed in a way that maximizes its value in the eyes of a potential buyer.
An owner also needs to spread the word. Most savvy business buyers use the Internet to research available businesses for sale, so post the sale notice on the two largest websites:[135]BizBuySell.com, self-described as the “Internet’s Largest Business for Sale Marketplace,” and BizQuest.com, self-described as the “Original Business for Sale Website.”
Key Takeaways
• The most emotional topic an owner will face when building a business—and the hardest decision he or she will probably have to make—is when and how to exit.
• An exit strategy should be planned while running the business. Unfortunately, many small businesses do not have an exit plan.
• There are many exit strategies that a small business owner can consider, including liquidation or walkaway, family succession, selling the business, bankruptcy, and taking a company public.
• The best exit strategy is the one that best matches the small business and the owner’s personal and professional goals.
• Liquidation is the selling of all assets. If all debts are paid, it can also be referred to as a walkaway. Walking away is the cleanest and best way to exit a business.
• Family succession is the transference of leadership from one generation to the next to ensure continuity of family ownership in the business. It is a critical issue in family businesses because few family firms survive beyond the first generation and even fewer survive into the third generation.
• The failure to plan for succession is seen as a basic human resource problem as well as the primary cause for the poor survival rate of family businesses.
• Bankruptcy is an extreme exit strategy that uses a legal method for closing a business and paying off creditors when a business is failing and the debts are substantially greater than the assets.
• Debt negotiations, operational improvements, or business turnaround and restructuring are alternatives to bankruptcy.
• An IPO is a stock offering in which the owner or owners of equity in a business have their private holdings transferred into issues tradable in public markets, such as the NYSE.
• There are several options for selling a business: acquisition, friendly buyout, selling to the employees, and selling in the open market.
• An acquisition is when another business buys a business. In an acquisition, there is no limit on the perceived value of the business.
• A friendly buyout is the transfer of ownership to family members, customers, employees, current managers, children, or friends—but it is still a sale.
• Selling to the employees can be a win-win situation because they get an established business that they know a great deal about already, and the owner gets enthusiastic buyers who want to see a business continue to thrive.
• Selling in the open market is the most popular exit strategy for small businesses.
• It has been estimated that 75 percent of small businesses do not sell, so a business must market in a way that maximizes its value in the eyes of the potential buyer.
Exercises
1. Two executives of a regional food company are regular customers and big fans of Frank’s All-American BarBeQue. They recently learned that Frank has been selling his sauces in local grocery stores and have been a big hit. The executives bought jars of each flavor, took them back to their company, and talked to the people who would decide about adding products to their line. Everyone loved the sauces, and there was definite interest in acquiring the sauce-making side of Frank’s business. It would fill a hole in their product line that they had been looking to fill.
The company contacted Frank about its interest, and Frank—with some urging from his son, Robert—is thinking about it. It would provide Frank with a nice retirement (when he decides to do that), money for his son and daughter, and a legacy. How should Frank proceed?
1. Source: Interview with John Bello, cofounder of SoBe, August 23, 2011.
2. “Planning Can Cut Disaster Recovery Time, Expense,” US Small Business Administration, accessed February 6, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da_dprep_howtoprep.pdf.
3. Darrell Zahorsky, “Disaster Recovery Decision Making for Small Business,” About.com, accessed February 6, 2012, sbinformation.about.com/od/disastermanagement/a/disasterrecover.htm.
4. Darrell Zahorsky, “Disaster Recovery Decision Making for Small Business,” About.com, accessed February 6, 2012, sbinformation.about.com/od/disastermanagement/a/disasterrecover.htm.
5. “Declared Disasters by Year and State,” Federal Emergency Management Agency, accessed February 6, 2012, http://www.fema.gov/news/disaster_totals_annual.fema.
6. “Planning Can Cut Disaster Recovery Time, Expense,” US Small Business Administration, accessed February 6, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da_dprep_howtoprep.pdf.
7. F. John Reh, “Survive the Unthinkable through Crisis Planning,” About.com, accessed February 6, 2012, management.about.com/cs/communication/a/PlaceBlame1000.htm.
8. Darrell Zahorsky, “Disaster Recovery Decision Making for Small Business,” About.com, accessed February 6, 2012, sbinformation.about.com/od/disastermanagement/a/disasterrecover.htm.
9. “Man-Made Disaster,” BusinessDictionary.com, accessed February 6, 2012, http://www.businessdictionary.com/definition/man-made-disaster.html.
10. “Anthropogenic Hazard,” Wikipedia, accessed February 6, 2012, en.Wikipedia.org/wiki/List_of_man-made_disasters.
11. “Disaster Preparedness: FAQs,” US Small Business Administration, accessed February 6, 2012, sbaonline.sba.gov/services/disasterassistance/disasterpreparedness/serv_da _dprep_howcaniprep.html.
12. “Planning Can Cut Disaster Recovery Time, Expense,” US Small Business Administration, accessed February 6, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da_dprep_howtoprep.pdf.
13. F. John Reh, “Survive the Unthinkable through Crisis Planning,” About.com, accessed February 6, 2012, management.about.com/cs/communication/a/PlaceBlame1000.htm.
14. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
15. Source: http://www.ready.gov/business.
16. “Fires,” American Red Cross, accessed February 6, 2012, http://www.sdarc.org/HowWeHelp/DisasterPreparedness/Fire/tabid/81/Default.aspx.
17. “How to Create a Business Continuity Plan,” wikiHow, accessed February 6, 2012, http://www.wikihow.com/Create-a-Business-Continuity-Plan.
18. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business
19. “How to Create a Business Continuity Plan,” wikiHow, accessed February 6, 2012, http://www.wikihow.com/Create-a-Business-Continuity-Plan.
20. “Disaster Preparedness: FAQs,” US Small Business Administration, accessed June 1, 2012, http://archive.sba.gov/services/disasterassistance/disasterpreparedness/serv _da_dprep_howcaniprep.html.
21. Kristie Lorette, “Importance of Good Communication in Business,” Chron.com, accessed February 6, 2012, smallbusiness.chron.com/importance-good -communication-business-1403.html.
22. Leslie Schwab, “Small Business: The Importance of Strong Communication Skills,” Helium, June 20, 2009, accessed February 6, 2012, http://www.helium.com/items/1486526-strong-communication-skills-are-required-for-success-in-small-business.
23. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
24. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
25. Darrell Zahorsky, “Disaster Recovery Decision Making for Small Business,” About.com, accessed February 6, 2012, sbinformation.about.com/od/disastermanagement/a/disasterrecover.htm.
26. John H. Ehrenreich, “Coping with Disasters: A Guidebook to Psychosocial Intervention,” Toolkit Sport for Development, October 2001, accessed February 6, 2012, http://www.toolkitsportdevelopment.org/html/resources/7B/7BB3B250-3EB8-44C6-AA8E -CC6592C53550/CopingWithDisaster.pdf.
27. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
28. “Insurance Coverage Review Worksheet,” Ready.gov, accessed February 6, 2012, http://www.ready.gov/sites/default/files/documents/files/InsuranceReview_Worksheet.pdf.
29. “Disaster Preparedness: FAQs,” US Small Business Administration, accessed June 1, 2012, http://archive.sba.gov/services/disasterassistance/disasterpreparedness/serv _da_dprep_howcaniprep.html.
30. “Business Interruption Insurance,” Entrepreneur, accessed February 6, 2012, http://www.entrepreneur.com/encyclopedia/term/82282.html.
31. “Business Interruption Insurance,” Entrepreneur, accessed February 6, 2012, http://www.entrepreneur.com/encyclopedia/term/82282.html.
32. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
33. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
34. “CyberSecurity by Chubb,” Chubb Group of Insurance Companies, accessed February 6, 2012, http://www.chubb.com/businesses/csi/chubb822.html.
35. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business.
36. “Plan For and Protect Your Business,” Ready.gov, accessed February 29, 2012, http://www.ready.gov/business
37. “Cyber Security Liability Insurance,” Wall Street Journal, March 18, 2010, as cited in Robert Hess and Company Insurance Brokers, May 6, 2010, accessed February 6, 2012, robhessco.com/183/cyber-security-liability-insurance/
38. Eric Schwartzel, “Cybersecurity Insurance: Many Companies Continue to Ignore the Issue,” Pittsburg Post-Gazette, June 22, 2010, accessed February 6, 2012, http://www.post-gazette.com/pg/10173/1067262-96.stm.
39. Darrell Zahorsky, “Disaster Recovery Decision Making for Small Business,” About.com, accessed February 6, 2012, sbinformation.about.com/od/disastermanagement/a/disasterrecover.htm.
40. “Disaster Assistance For Businesses of All Sizes,” US Small Business Administration, accessed February 28, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da _dprep_factsheethome.pdf.
41. “Disaster Assistance For Businesses of All Sizes,” US Small Business Administration, accessed February 28, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da _dprep_factsheethome.pdf.
42. See, for example, the small business loans that are available through the Union County Economic Development Corporation (Union, New Jersey) for disaster assistance: scotchplains.patch.com/articles/union-county-makes-small-business-loans -available.
43. “Demand Grows for Disaster Loans,” Wall Street Journal, September 7, 2011, accessed February 6, 2012, blogs.wsj.com/in-charge/2011/09/07/demand-grows-for-disaster -loans/?mod=google_news_blog.
44. “Disaster Assistance For Businesses of All Sizes,” US Small Business Administration, accessed February 28, 2012, archive.sba.gov/idc/groups/public/documents/sba_homepage/serv_da _dprep_factsheethome.pdf.
45. “Disaster Assistance and Emergency Relief for Individuals and Businesses,” Internal Revenue Service, accessed February 6, 2012, http://www.irs.gov/businesses/small/article/0,,id=156138,00.html.
46. “About SCORE,” SCORE, accessed February 6, 2012, http://www.score.org/about-score.
47. “Disaster Assistance and Emergency Relief for Individuals and Businesses,” Internal Revenue Service, accessed February 6, 2012, http://www.irs.gov/businesses/small/article/0,,id=156138,00.html
48. “What Is DisasterAssistance.gov,” DisasterAssistance.gov, accessed February 6, 2012, http://www.disasterassistance.gov.
49. “Disaster Assistance and Emergency Relief for Individuals and Businesses,” Internal Revenue Service, accessed February 6, 2012, http://www.irs.gov/businesses/small/article/0,,id=156138,00.html
50. “Looking for Benefits?,” accessed February 6, 2012, http://www.benefits.gov.
51. “Knowing When to Throw in the Towel,” Fox Business, May 2, 2011, accessed February 6, 2012, smallbusiness.foxbusiness.com/entrepreneurs/2011/05/02/knowing -throw-towel.
52. Timothy Faley, “Making Your Exit,” Inc., March 1, 2006, accessed February 6, 2012, http://www.inc.com/resources/startup/articles/20060301/tfaley.html
53. “Knowing When to Throw in the Towel,” Fox Business, May 2, 2011, accessed February 6, 2012, smallbusiness.foxbusiness.com/entrepreneurs/2011/05/02/knowing-throw-towel.
54. Dan Bigman, “On the Hunt,” Forbes 185, no. 2 (2009): 56–59
55. Noam Wasserman, “The Founder’s Dilemma,” Harvard Business Review, February 2008, 1–8
56. Noam Wasserman, “The Founder’s Dilemma,” Harvard Business Review, February 2008, 1–8
57. Noam Wasserman, “The Founder’s Dilemma,” Harvard Business Review, February 2008, 1–8
58. Dan Bigman, “On the Hunt,” Forbes 185, no. 2 (2009): 56–59
59. Noam Wasserman, “The Founder’s Dilemma,” Harvard Business Review, February 2008, 1–8
60. Richard Carter and Howard Van Auken, “Small Firm Bankruptcy,” Journal of Small Business Management 44, no. 4 (2006): 493–512.
61. Geoff Williams, “Dead Zone,” Entrepreneur, March 2007, accessed February 6, 2012, http://www.entrepreneur.com/magazine/entrepreneur/2007/march/174716.html.
62. Leigh Buchanan, “A Fight for Survival: When the Boss Gets Cancer,” Inc., July/August 2009, 106, 108
63. Joel Spolsky, “The Day My Industry Died,” Inc., July/August 2009, 37–38
64. Sarah E. Needleman, Vanessa O’Connell, Emily Maltby, and Angus Loten, “And the Most Innovative Entrepreneur Is…,” Wall Street Journal, November 14, 2011, accessed February 6, 2012, online.wsj.com/article/SB10001424052970203716204577013501641346794.html.
65. Timothy Faley, “Making Your Exit,” Inc., March 1, 2006, accessed February 6, 2012, http://www.inc.com/resources/startup/articles/20060301/tfaley.html.
66. “Consider Your Exit Strategy When Starting Up: Why You Need an Exit Strategy,” Business Link, accessed February 6, 2012, http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073792644&type=RESOURCES.
67. Susan Ward, “Exit Strategies for Your Small Business,” About.com, accessed June 1, 2012, sbinfocanada.about.com/od/businessplanning/a/exitstrategies.htm.
68. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
69. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke.
70. “Goodwill,” Investopedia, accessed February 6, 2012, http://www.investopedia.com/terms/g/goodwill.asp.
71. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke.
72. “Badwill,” Investopedia, accessed February 6, 2012, http://www.investopedia.com/terms/b/badwill.asp.
73. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
74. Jerome A. Katz and Richard P. Green, Entrepreneurial Small Business (New York: McGraw-Hill Irwin, 2009), 663.
75. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke
76. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
77. Susan Ward, “Exit Strategies for Your Small Business,” About.com, accessed February 6, 2012, sbinfocanada.about.com/od/businessplanning/a/exitstrategies.htm.
78. Sue Birley, “Succession in the Family Firm: The Inheritor’s View,” Journal of Small Business Management 24, no. 3 (1986): 36–43
79. Manfred F. R. Kets de Vries, “The Dynamics of Family Controlled Firms: The Good News and the Bad News,” Organizational Dynamics 21, no. 3 (1993), 59–68
80. Michael H. Morris, Roy O. Williams, Jeffrey A. Allen, and Ramon A. Avila, “Correlates of Success in Family Business Transitions,” Journal of Business Venturing 12 (1997): 385–401
81. Wendy C. Handler, “Succession in Family Business: A Review of the Literature,” Family Business Review 7, no. 2 (1994): 133–57
82. Stanley M. Davis, “Entrepreneurial Succession,” Administrative Science Quarterly 13 (1968): 402–16, as cited in A. Bakr Ibrahim, Khaled Soufani, Panikkos Poutziouris, and Jose Lam, “Qualities of an Effective Successor: The Role of Education and Training,” Education and Training 46, no. 8/9 (2004): 474–80.
83. A. Bakr Ibrahim, Khaled Soufani, Panikkos Poutziouris, and Jose Lam, “Qualities of an Effective Successor: The Role of Education and Training,” Education and Training 46, no. 8/9 (2004): 474–80
84. Katiuska Cabrera-Suarez, “Leadership Transfer and the Successor’s Development in the Family Firm,” The Leadership Quarterly 16 (2005): 71–96
85. Katiuska Cabrera-Suarez, “Leadership Transfer and the Successor’s Development in the Family Firm,” The Leadership Quarterly 16 (2005): 71–96
86. Katiuska Cabrera-Suarez, “Leadership Transfer and the Successor’s Development in the Family Firm,” The Leadership Quarterly 16 (2005): 71–96.
87. A. Bakr Ibrahim, Khaled Soufani, Panikkos Poutziouris, and Jose Lam, “Qualities of an Effective Successor: The Role of Education and Training,” Education and Training 46, no. 8/9 (2004): 474–80
88. Stephan van der Merwe, Elmarie Venter, and Suria M. Ellis, “An Exploratory Study of Some of the Determinants of Management Succession Planning in Family Businesses,” Management Dynamics 18, no. 4 (2009): 2–17.
89. Jerome A. Katz and Richard P. Green, Entrepreneurial Small Business (New York: McGraw-Hill Irwin, 2009), 663
90. “Bankruptcy,” US Small Business Administration, accessed February 6, 2012, http://www.sba.gov/content/bankruptcy.
91. Caron Beesley, “Bankruptcy Options for the Small Business Owner,” AllBusiness.com , February 5, 2009, accessed February 6, 2012, http://www.allbusiness.com/company-activities-management/company-structures-ownership/11772426-1.html
92. “Small Business Bankruptcy…You Have Choices,” Daniel B. James Group, accessed February 6, 2012, http://www.small-business-bankruptcy.com.
93. Caron Beesley, “Bankruptcy Options for the Small Business Owner,” AllBusiness.com, February 5, 2009, accessed February 6, 2012, http://www.allbusiness.com/company-activities-management/company-structures-ownership/11772426-1.html
94. “Small Business Bankruptcy…You Have Choices,” Daniel B. James Group, accessed February 6, 2012, http://www.small-business-bankruptcy.com.
95. “Small Business Bankruptcy…You Have Choices,” Daniel B. James Group, accessed February 6, 2012, http://www.small-business-bankruptcy.com.
96. Caron Beesley, “Bankruptcy Options for the Small Business Owner,” AllBusiness.com, February 5, 2009, http://www.allbusiness.com/company-activities-management/company-structures-ownership/11772426-1.html.
97. “Bankruptcy,” US Small Business Administration, accessed February 6, 2012, http://www.sba.gov/content/bankruptcy.
98. “Small Business Bankruptcy…You Have Choices,” Daniel B. James Group, accessed February 6, 2012, http://www.small-business-bankruptcy.com.
99. Timothy Faley, “Making Your Exit,” Inc., March 1, 2006, accessed February 6, 2012, http://www.inc.com/resources/startup/articles/20060301/tfaley.html.
100. Timothy Faley, “Making Your Exit,” Inc., March 1, 2006, accessed February 6, 2012, http://www.inc.com/resources/startup/articles/20060301/tfaley.html.
101. “IPOs in 2011,” Upcoming-IPOs.com, August 23, 2011, accessed February 6, 2012, upcoming-ipos.com/ipos-in-2011
102. Trent Tillman, “2010 Year-End U.S. IPO Review and 2011 Outlook,” Syndicate Trader, March 4, 2011, accessed February 6, 2012, syndicatetrader.wordpress.com/2011/03/04/2010-year-end-u-s-ipo-review-and-2011 -outlook.
103. Douglas W. Campbell, “2011 IPO Review & 2012 Outlook,” Triad Securities, January 6, 2012, accessed February 28, 2012, http://www.triadsecurities.com/ipo_review/20120106.
104. Example of Canadian IPOs: https://www.theglobeandmail.com/globe-investor/canadas-ipo-landscape/article28107637/
105. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke.
106. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
107. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
108. J. G. Pellegrin, “Toward a Model of Making and Executing the Decision to Sell: An Exploratory Study of the Sale of Family Owned Companies” (PhD diss.), Lausanne Business School, Switzerland, 1999, as cited in Christian Niedermeyer, Peter Jaskiewicz, and Sabine B. Klein, “’Can’t Get to Satisfaction?’ Evaluating the Sale of the Family Business from the Family’s Perspective and Driving Implications for New Venture Activities,” Entrepreneurship & Regional Development 22, no. 3–4 (2010): 293–320.
109. Barbara Taylor, “How to Sell Your Business,” New York Times, January 7, 2010, accessed February 6, 2012, http://www.nytimes.com/2010/01/07/business/smallbusiness/07guide.html
110. Anthony Tjan, “The Founder’s Dilemma: To Sell or Not to Sell?,” Harvard Business Review, February 18, 2011, accessed February 6, 2012, blogs.hbr.org/tjan/2011/02/the-founders-dilemma-to-sell-o.html.
111. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke.
112. Barbara Taylor, “How to Sell Your Business,” New York Times, January 7, 2010, accessed February 6, 2012, http://www.nytimes.com/2010/01/07/business/smallbusiness/07guide.html.
113. “Vulture Capitalist,” Investopedia, accessed February 6, 2012, http://www.investopedia.com/terms/v/vulturecapitalist.asp
114. “Vulture Capitalist,” Urban Dictionary, November 12, 2009, accessed February 6, 2012, http://www.urbandictionary.com/define.php ?term=Vulture%20Capitalist.
115. “Venture Capitalist,” Investopedia, accessed February 6, 2012, http://www.investopedia.com/terms/v/venturecapitalist.asp.
116. Interview with John Bello, cofounder of SoBe, August 23, 2011.
117. Susan Ward, “Exit Strategies for Your Small Business,” About.com, accessed February 6, 2012, sbinfocanada.about.com/od/businessplanning/a/exitstrategies.htm.
118. Interview with John Bello, cofounder of SoBe, August 23, 2011.
119. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
120. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
121. George W. Keeley, “Non-Compete Agreements: Are They Enforceable?,” KK&R, accessed February 29, 2012, http://www.kkrlaw.com/articles/noncomp.htm.
122. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for-Small -Business-Owners-By-Andrew-Clarke
123. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
124. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies -for-Small-Business-Owners-By-Andrew-Clarke
125. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
126. Andrew Clarke, “Exit Strategies for Small Business Owners,” Experts.com, 2006, accessed February 6, 2012, http://www.experts.com/Articles/Exit-Strategies-for -Small-Business-Owners-By-Andrew-Clarke
127. Stever Robbins, “Exit Strategies for Your Business,” Entrepreneur, June 27, 2005, accessed February 6, 2012, http://www.entrepreneur.com/article/78512.
128. Susan Ward, “Exit Strategies for Your Small Business,” About.com, accessed February 6, 2012, sbinfocanada.about.com/od/businessplanning/a/exitstrategies.htm.
129. Monica Mehta, “Alternative Exits for Business Owners,” Bloomberg BusinessWeek, July 27, 2010, accessed February 6, 2012, http://www.BusinessWeek.com/smallbiz/content/jul2010/sb20100727_564778.htm.
130. Barbara Taylor, “A Creative Way to Sell Your Business,” New York Times, October 29, 2010, accessed February 6, 2012, boss.blogs.nytimes.com/2010/10/29/a -creative-way-to-sell-your-business.
131. Barbara Taylor, “A Creative Way to Sell Your Business,” New York Times, October 29, 2010, accessed February 6, 2012, boss.blogs.nytimes.com/2010/10/29/a -creative-way-to-sell-your-business.
132. Barbara Taylor, “A Creative Way to Sell Your Business,” New York Times, October 29, 2010, accessed February 6, 2012, boss.blogs.nytimes.com/2010/10/29/a -creative-way-to-sell-your-business.
133. Susan Ward, “Exit Strategies for Your Small Business,” About.com, accessed February 6, 2012, sbinfocanada.about.com/od/businessplanning/a/exitstrategies.htm.
134. Harvey Zemmel, “Top 7 Ways to Maximize Your Exit Strategy for Maximum Profit,” About.com, accessed February 6, 2012, sbinfocanada.about.com/od/sellingabusiness/a/exitstrategyhz.htm.
135. Barbara Taylor, “A Creative Way to Sell Your Business,” New York Times, October 29, 2010, accessed February 6, 2012, boss.blogs.nytimes.com/2010/10/29/a-creative-way-to-sell-your-business. | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.03%3A_Chapter_6-_Icebergs_and_Escapes.txt |
The Team and the Organization
Learning Objectives
1. Define a team and describe its key characteristics.
2. Explain why organizations use teams, and describe different types of teams.
What Is a Team? How Does Teamwork Work?
A team (or a work team) is a group of people with complementary skills who work together to achieve a specific goal.[1] In the case of Motorola’s RAZR team, the specific goal was to develop (and ultimately bring to market) an ultrathin cell phone that would help restore the company’s reputation as a designer of stylistically appealing, high-function phones. The team achieved its goal by integrating specialized but complementary skills in engineering and design and by making the most of its authority to make its own decisions and manage its own operations.
Teams versus Groups
“A group,” suggests Bonnie Edelstein, a consultant in organizational development, “is a bunch of people in an elevator. A team is also a bunch of people in an elevator, but the elevator is broken.” This distinction may be a little oversimplified, but as our tale of teamwork at Motorola reminds us, a team is clearly something more than a mere group of individuals. In particular, members of a group—or, more accurately, a working group—go about their jobs independently and meet primarily to share information. A group of department-store managers, for example, might meet monthly to discuss their progress in cutting plant costs, but each manager is focused on the goals of his or her department because each is held accountable for meeting only those goals. Teams, by contrast, are responsible for achieving specific common goals, and they’re generally empowered to make the decisions needed to complete their authorized tasks.
Some Key Characteristics of Teams
To keep matters in perspective, let’s identify five key characteristics of work teams:[2][3]
1. Teams are accountable for achieving specific common goals. Members are collectively responsible for achieving team goals, and if they succeed, they’re rewarded collectively.
2. Teams function interdependently. Members cannot achieve goals independently and must rely on each other for information, input, and expertise.
3. Teams are stable. Teams remain intact long enough to finish their assigned tasks, and each member remains on board long enough to get to know every other member.
4. Teams have authority. Teams possess the decision-making power to pursue their goals and to manage the activities through which they complete their assignments.
5. Teams operate in a social context. Teams are assembled to do specific work for larger organizations and have the advantage of access to resources available from other areas of their organizations.
Why Organizations Build Teams
Why do major organizations now rely more and more on teams to improve operations? Executives at Xerox have reported that team-based operations are 30 percent more productive than conventional operations. General Mills says that factories organized around team activities are 40 percent more productive than traditionally organized factories. According to in-house studies at Shenandoah Life Insurance, teams have cut case-handling time from twenty-seven to two days and virtually eliminated service complaints. FedEx says that teams reduced service errors (lost packages, incorrect bills) by 13 percent in the first year.[4][5]
Today it seems obvious that teams can address a variety of challenges in the world of corporate activity. Before we go any further, however, we should remind ourselves that data like those we’ve just cited aren’t necessarily definitive. For one thing, they may not be objective—companies are more likely to report successes than failures. As a matter of fact, teams don’t always work. Indeed, according to one study, team-based projects fail 50 to 70 percent of the time.[6][7]
The Effect of Teams on Performance
Research shows that companies build and support teams because of their effect on overall workplace performance, both organizational and individual. If we examine the impact of team-based operations according to a wide range of relevant criteria—including product quality, worker satisfaction, and quality of work life, among others—we find that overall organizational performance improves. Table 7.1 “Effect of Teams on Workplace Performance” lists several areas in which we can analyze workplace performance and indicates the percentage of companies that have reported improvements in each area.
Table 7.1 Effect of Teams on Workplace Performance [8]
Area of Performance Percent of Firms Reporting Improvement
Product and service quality 70
Customer service 67
Worker satisfaction 66
Quality of work life 63
Productivity 61
Competitiveness 50
Profitability 45
Absenteeism/turnover 23
Teams, then, can improve company and individual performance in a number of areas. Not all teams, however, are formed to achieve the same goals or charged with the same responsibilities. Nor are they organized in the same way. Some, for instance, are more autonomous than others—less accountable to those higher up in the organization. Some depend on a team leader who’s responsible for defining the team’s goals and making sure that its activities are performed effectively. Others are more or less self-governing: though a leader lays out overall goals and strategies, the team itself chooses and manages the methods by which it pursues its goals and implements its strategies.[9] Teams also vary according to their membership. Let’s look at several categories of teams.
Manager-Led Teams
As its name implies, in the manager-led team, the manager is the team leader and is in charge of setting team goals, assigning tasks, and monitoring the team’s performance. The individual team members have relatively little autonomy. For example, the key employees of a professional football team (a manager-led team) are highly trained (and highly paid) athletes, but their activities on the field are tightly controlled by a head coach. As team manager, the coach is responsible both for developing the strategies by which the team pursues its goal of winning games and for the final outcome of each game (not to mention the season). He’s also solely responsible for interacting with managers above him in the organization. The players are responsible only for executing plays.[10]
Self-Managing Teams
Self-managing teams (also known as self-directed or self-regulating teams) have considerable autonomy. They are usually small and often absorb activities that were once performed by traditional supervisors. A manager or team leader may determine overall goals, but the members of the self-managing team control the activities needed to achieve the goals, such as planning and scheduling work, sharing tasks, meeting quality standards, and handling day-to-day operations.
Self-managing teams are the organizational hallmark of Whole Foods Market, the largest natural-foods grocer in the United States. Each store is run by ten teams (produce, prepared foods, and so forth), and virtually every store employee is a member of a team. Each team has a designated leader and its own performance targets. (Team leaders also belong to a store team, and store-team leaders belong to a regional team.) To do its job, every team has access to the kind of information—including sales and even salary figures—that most companies reserve for the eyes of traditional managers.[11]
Needless to say, not every self-managed team enjoys the same degree of autonomy. Companies vary widely in choosing which tasks teams are allowed to manage and which ones are best left to upper-level management only. As you can see in Figure 7.1 “What Teams Do (and Don’t) Manage”, for example, self-managing teams are often allowed to schedule assignments, but they are rarely allowed to fire coworkers.
Cross-Functional Teams
Many companies use cross-functional teams —teams that, as the name suggests, cut across an organization’s functional areas (operations, marketing, finance, and so on). A cross-functional team is designed to take advantage of the special expertise of members drawn from different functional areas of the company. When the Internal Revenue Service, for example, wanted to study the effects on employees of a major change in information systems, it created a cross-functional team composed of people from a wide range of departments. The final study reflected expertise in such areas as job analysis, training, change management, industrial psychology, and even ergonomics.[12]
Cross-functional teams figure prominently in the product-development process at Nike, where they take advantage of expertise from both inside and outside the company. Typically, team members include not only product designers, marketing specialists, and accountants but also sports-research experts, coaches, athletes, and even consumers. Likewise, Motorola’s RAZR team was a cross-functional team: Responsibility for developing the new product wasn’t passed along from the design team to the engineering team but rather was entrusted to a special team composed of both designers and engineers.
We can also classify the RAZR team as a product-development or project team (a topic we’ll discuss in more detail in Chapter 10 “Product Design and Development”). Committees and task forces, both of which are dedicated to specific issues or tasks, are often cross-functional teams. Problem-solving teams, which are created to study such issues as improving quality or reducing waste, may be either intradepartmental or cross-functional.[13]
Virtual Teams
“Teamwork,” said someone (we’re not sure who), “doesn’t tolerate the inconvenience of distance.” Indeed, technology now makes it possible for teams to function not only across such organizational boundaries as functional areas, departments, and divisions but also across time and space, as well. Working in virtual teams, geographically dispersed members interact electronically in the process of pursuing a common goal. Such technologies as videoconferencing, instant messaging, and electronic meetings, which allow people to interact simultaneously and in real time, offer a number of advantages in conducting the business of a virtual team.[14] Among other things, members can participate from any location or at any time of day, and teams can “meet” for as long as it takes to achieve a goal or solve a problem—a few days, a few weeks, or a few months.
Nor does team size seem to be an obstacle when it comes to calling virtual-team meetings: In building the F-35 Strike Fighter, U.S. defense contractor Lockheed Martin staked the \$225 billion project on a virtual product-team of unprecedented global dimension, drawing on designers and engineers from the ranks of eight international partners ranging from Canada and the United Kingdom to Norway and Turkey.[15]
Key Takeaways
• Teamwork brings diverse areas of expertise to bear on organizational problems and projects.
• Reaching teamwork goals requires skills in negotiating trade-offs, and teamwork brings these skills into play at almost every step in the process.
• To be successful, teams need a certain amount of autonomy and authority in making and implementing their decisions.
• A team (or a work team) is a group of people with complementary skills who work together to achieve a specific goal. Members of a working group work independently and meet primarily to share information.
• Work teams have five key characteristics:
1. They are accountable for achieving specific common goals.
2. They function interdependently.
3. They are stable.
4. They have authority.
5. They operate in a social context.
• Companies build and support teams because of their effect on overall workplace performance, both organizational and individual.
• Work teams may be of several types:
1. In the traditional manager-led team, the leader defines the team’s goals and activities and is responsible for its achieving its assigned goals.
2. The leader of a self-managing team may determine overall goals, but employees control the activities needed to meet them.
3. A cross-functional team is designed to take advantage of the special expertise of members drawn from different functional areas of the company.
4. On virtual teams, geographically dispersed members interact electronically in the process of pursuing a common goal.
Exercise
(AACSB) Analysis
You’re a marketing researcher for a multinational food-products corporation, and for the past two years, you’ve been able to work at home. The international division of the company has asked you to join a virtual team assigned to assess the prospects for a new sandwich planned for the Indian market.
List a few of the challenges that you’re likely to encounter as a member of the virtual team. Explain the steps you’d take to deal with each of the challenges that you’ve listed.
Why Teamwork Works
Learning Objectives
1. Explain why teams may be effective or ineffective.
2. Identify factors that contribute to team cohesiveness.
Now that we know a little bit about how teams work, we need to ask ourselves why they work. Not surprisingly, this is a fairly complex issue. In this section, we’ll answer these closely related questions: Why are teams often effective? Why are they sometimes ineffective?
Factors in Effective Teamwork
First, let’s begin by identifying several factors that, in practice, tend to contribute to effective teamwork. Generally speaking, teams are effective when the following factors are met:[16]
• Members depend on each other. When team members rely on each other to get the job done, team productivity and efficiency are high.
• Members trust one another. Teamwork is more effective when members trust each other.
• Members work better together than individually. When team members perform better as a group than alone, collective performance exceeds individual performance.
• Members become boosters. When each member is encouraged by other team members to do his or her best, collective results improve.
• Team members enjoy being on the team. The more that team members derive satisfaction from being on the team, the more committed they become.
• Leadership rotates. Teams function effectively when leadership responsibility is shared over time.
Most of these explanations probably make pretty clear intuitive sense. Unfortunately, because such issues are rarely as clear-cut as they may seem at first glance, we need to examine the issue of group effectiveness from another perspective—one that considers the effects of factors that aren’t quite so straightforward.
Group Cohesiveness
The idea of group cohesiveness refers to the attractiveness of a team to its members. If a group is high in cohesiveness, membership is quite satisfying to its members; if it’s low in cohesiveness, members are unhappy with it and may even try to leave it. The principle of group cohesiveness, in other words, is based on the simple idea that groups are most effective when their members like being members of the group.[17][18]
What Makes a Team Cohesive?
Numerous factors may contribute to team cohesiveness, but in this section, we’ll focus on five of the most important:
1. Size. The bigger the team, the less satisfied members tend to be. When teams get too large, members find it harder to interact closely with other members; a few members tend to dominate team activities, and conflict becomes more likely.
2. Similarity. People usually get along better with people like themselves, and teams are generally more cohesive when members perceive fellow members as people who share their own attitudes and experience.
3. Success. When teams are successful, members are satisfied, and other people are more likely to be attracted to their teams.
4. Exclusiveness. The harder it is to get into a group, the happier the people who are already in it. Status (the extent to which outsiders look up to a team, as well as the perks that come with membership) also increases members’ satisfaction.
5. Competition. Members value membership more highly when they’re motivated to achieve common goals—especially when those goals mean outperforming other teams.
Figure 7.2 Cohesive Teams
There’s such a thing as too much cohesiveness. When, for instance, members are highly motivated to collaborate in performing the team’s activities, the team is more likely to be effective in achieving its goals. Clearly, when those goals are aligned with the goals of the larger organization, the organization, too, will be happy. If, however, its members get too wrapped up in more immediate team goals, the whole team may lose sight of the larger organizational goals toward which it’s supposed to be working.
Groupthink
Likewise, it’s easier for leaders to direct members toward team goals when members are all on the same page—when there’s a basic willingness to conform to the team’s rules and guidelines. When there’s too much conformity, however, the group can become ineffective: It may resist change and fresh ideas and, what’s worse, may end up adopting its own dysfunctional tendencies as its way of doing things. Such tendencies may also encourage a phenomenon known as groupthink—the tendency to conform to group pressure in making decisions, while failing to think critically or to consider outside influences.
Groupthink is often cited as a factor in the explosion of the space shuttle Challenger in January 1986: Engineers from a supplier of components for the rocket booster warned that the launch might be risky because of the weather but were persuaded to reverse their recommendation by NASA officials who wanted the launch to proceed as scheduled.[19]
Why Teams Fail
Teams don’t always work. To learn why, let’s take a quick look at four common obstacles to success in introducing teams into an organization:[20]
• Unwillingness to cooperate. Failure to cooperate can occur when members don’t or won’t commit to a common goal or set of activities. What if, for example, half the members of a product-development team want to create a brand-new product and half want to improve an existing product? The entire team may get stuck on this point of contention for weeks or even months.
• Lack of managerial support. Every team requires organizational resources to achieve its goals, and if management isn’t willing to commit the needed resources—say, funding or key personnel—a team will probably fall short of those goals.
• Failure of managers to delegate authority. Team leaders are often chosen from the ranks of successful supervisors—first-line managers who, as we saw in Chapter 6 “Managing for Business Success”, give instructions on a day-to-day basis and expect to have them carried out. This approach to workplace activities may not work very well in leading a team—a position in which success depends on building a consensus and letting people make their own decisions.
• Failure of teams to cooperate. If you’re on a workplace team, your employer probably depends on teams to perform much of the organization’s work and meet many of its goals. In other words, it is, to some extent, a team-based organization, and as such, reaching its overall goals requires a high level of cooperation among teams.[21] When teams can’t agree on mutual goals (or when they duplicate efforts), neither the teams nor the organization is likely to meet with much success.
Motivation and Frustration
Finally, remember that teams are composed of people, and whatever the roles they happen to be playing at a given time, people are subject to psychological ups and downs. As members of workplace teams, they need motivation, when motivation is down, so are effectiveness and productivity. As you can see in Figure 7.3 “Sources of Frustration”, the difficulty of maintaining a high level of motivation is the chief cause of frustration among members of teams. As such, it’s also a chief cause of ineffective teamwork, and that’s one reason why more employers now look for the ability to develop and sustain motivation when they’re hiring new managers.[22]
Key Takeaways
• Generally speaking, teams are effective when the following are true:
1. Members are interdependent.
2. Members work better together than individually.
3. Teams work well enough to satisfy members.
4. Leadership rotates.
5. Members help one another.
6. Members become boosters.
7. Members trust one another.
• Group cohesiveness refers to the attractiveness of a team to its members. If a group is high in cohesiveness, membership is quite satisfying to its members; if it’s low in cohesiveness, members are unhappy with it and may even try to leave it.
• Common obstacles to team success include the following:
1. Unwillingness to cooperate
2. Lack of managerial support
3. Failure of managers to delegate authority
4. Failure of teams to cooperate
Exercise
(AACSB) Analysis
At some point in the coming week, while you’re working on an assignment for any one of your classes, ask at least one other member of the class to help you with it or to collaborate with you in studying for it. After you’ve completed your assignment, make a list of the advantages and disadvantages of working on the assignment with another person.
The Team and Its Members
Learning Objectives
1. Understand the importance of learning to participate in team-based activities.
2. Identify the skills needed by team members and the roles that members of a team might play.
3. Learn how to survive team projects in college (and actually enjoy yourself).
4. Explain the skills and behaviors that foster effective team leadership.
“Life Is All about Group Work”
“I’ll work extra hard and do it myself, but please don’t make me have to work in a group.”
Like it or not, you’ll probably be given some teamwork assignments while you’re in college. More than two-thirds of all students report having participated in the work of an organized team, and if you’re in business school, you will almost certainly find yourself engaged in team-based activities.[23][24]
Why do we put so much emphasis on something that, reportedly, makes many students feel anxious and academically drained? Here’s one college student’s practical-minded answer to this question:
In the real world, you have to work with people. You don’t always know the people you work with, and you don’t always get along with them. Your boss won’t particularly care, and if you can’t get the job done, your job may end up on the line. Life is all about group work, whether we like it or not. And school, in many ways, prepares us for life, including working with others”.[25]
She’s right. In placing so much emphasis on teamwork skills and experience, college business departments are doing the responsible thing—preparing students for the business world that awaits them. A survey of Fortune 1000 companies reveals that 79 percent already rely on self-managing teams and 91 percent on various forms of employee work groups. Another survey found that the skill that most employers value in new employees is the ability to work in teams.[26][27] If you’re already trying to work your way up an organizational ladder, consider the advice of former Chrysler Chairman Lee Iacocca: “A major reason that capable people fail to advance is that they don’t work well with their colleagues”.[28] The importance of the ability to work in teams was confirmed in a survey of leadership practices of more than sixty of the world’s top organizations.[29] When top executives in these organizations were asked, “What causes high-potential leadership candidates to derail? (stop moving up in the organization),” 60 percent of the organizations cited “inability to work in teams.” Interestingly, only 9 percent attributed the failure of these executives to advance to “lack of technical ability.” While technical skills will be essential in your getting hired into an organization, your team skills will play a significant role in your ability to advance.
To be team-ready or not to be team-ready—that is the question. Or, to put it in plainer terms, the question is not whether you’ll find yourself working as part of a team. You will. The question is whether you’ll know how to participate successfully in team-based activities.
Will You Make a Good Team Member?
What if your instructor in this course decides to divide the class into several three-, four-, or five-member teams and assigns each team to develop a new product plus a business plan to get it into production and out on the market? What teamwork skills could you bring to the table? What teamwork skills do you need to work on? What qualities do you possess that might make you a good team leader?
What Skills Does the Team Need?
Sometimes we hear about a sports team made up of mostly average players who win a championship because of coaching genius, flawless teamwork, and superhuman determination.[30] But not terribly often. In fact, we usually hear about such teams simply because they’re newsworthy—exceptions to the rule. Typically a team performs well because its members possess some level of talent. This doesn’t mean, however, that we should reduce team performance to the mere sum of its individual contributions: Members’ talents aren’t very useful if they’re not managed in a collective effort to achieve a common goal.
In the final analysis, of course, a team can succeed only if its members provide the skills that need managing. In particular, every team requires some mixture of three sets of skills:
• Technical skills. Because teams must perform certain tasks, they need people with the skills to perform them. For example, if your project calls for a lot of math work, it’s good to have someone with the necessary quantitative skills.
• Decision-making and problem-solving skills. Because every task is subject to problems, and because handling every problem means deciding on the best solution, it’s good to have members who are skilled in identifying problems, evaluating alternative solutions, and deciding on the best options.
• Interpersonal skills. Because teams are composed of people, and because people need direction and motivation and depend on communication, every group benefits from members who know how to listen, provide feedback, and smooth ruffled feathers. The same people are usually good at communicating the team’s goals and needs to outsiders.
The key to success is ultimately the right mix of these skills. Remember, too, that no team needs to possess all these skills—never mind the right balance of them—from day one. In many cases, a team gains certain skills only when members volunteer for certain tasks and perfect their skills in the process of performing them. For the same reason, effective teamwork develops over time as team members learn how to handle various team-based tasks. In a sense, teamwork is always work in progress.
What Roles Do Team Members Play?
Like your teamwork skills, expect your role on a team to develop over time. Also remember that, both as a student and as a member of the workforce, you’ll be a member of a team more often than a leader (a subject that we’ll take up in the next section). Team members, however, can have as much impact on a team’s success as its leaders. The key is the quality of the contributions they make in performing nonleadership roles.[31]
What, exactly, are those roles? At this point, you’ve probably concluded that every team faces two basic challenges:
1. Accomplishing its assigned task
2. Maintaining or improving group cohesiveness
Whether you affect the team’s work positively or negatively depends on the extent to which you help it or hinder it in meeting these two challenges.[32] We can thus divide teamwork roles into two categories, depending on which of these two challenges each role addresses. These two categories (task-facilitating roles and relationship-building roles) are summarized in Table 7.2 “Roles that Team Members Play”.
Table 7.2 Roles that Team Members Play [33]
Task-facilitating Roles Example Relationship-building Roles Example
Direction giving “Jot down a few ideas and we’ll see what everyone has come up with.” Supporting “Now, that’s what I mean by a practical application.”
Information seeking “Does anyone know if this is the latest data we have?” Harmonizing “Actually, I think you’re both saying pretty much the same thing.”
Information giving “Here are latest numbers from.…” Tension relieving “Before we go on to the next section, how many people would like a pillow?”
Elaborating “I think a good example of what you’re talking about is.…” Confronting “How does that suggestion relate to the topic that we’re discussing?”
Urging “Let’s try to finish this proposal before we adjourn.” Energizing “It’s been a long time since I’ve had this many laughs at a meeting in this department.”
Monitoring “If you’ll take care of the first section, I’ll make sure that we have the second by next week.” Developing “If you need some help pulling the data together, let me know.”
Process analyzing “What happened to the energy level in this room?” Consensus building “Do we agree on the first four points even if number five needs a little more work?”
Reality testing “Can we make this work and stay within budget?” Empathizing “It’s not you. The numbers are confusing.”
Enforcing “We’re getting off track. Let’s try to stay on topic.”
Summarizing “Before we jump ahead, here’s what we’ve decided so far.”
Task-facilitating roles address challenge number one—accomplishing the team goals. As you can see from Table 7.2 “Roles that Team Members Play”, such roles include not only providing information when someone else needs it but also asking for it when you need it. In addition, it includes monitoring (checking on progress) and enforcing (making sure that team decisions are carried out). Task facilitators are especially valuable when assignments aren’t clear or when progress is too slow. Moreover, every team needs people who recognize when a little task facilitation is called for.
Relationship-Building Roles
When you challenge unmotivated behavior or help other team members understand their roles, you’re performing a relationship-building role and addressing challenge number two—maintaining or improving group cohesiveness. This type of role includes just about every activity that improves team “chemistry,” from confronting to empathizing.
Bear in mind three points about this model of team-membership roles: (1) Teams are most effective when there’s a good balance between task facilitation and relationship building; (2) it’s hard for any given member to perform both types of roles, as some people are better at focusing on tasks and others on relationships; and (3) overplaying any facet of any role can easily become counterproductive. For example, elaborating on something may not be the best strategy when the team needs to make a quick decision; and consensus building may cause the team to overlook an important difference of opinion.
Blocking Roles
Finally, review Table 7.3 “How to Block Teamwork”, which summarizes a few characteristics of another kind of team-membership role. So-called blocking roles consist of behavior that inhibits either team performance or that of individual members. Every member of the team should know how to recognize blocking behavior. If teams don’t confront dysfunctional members, they can destroy morale, hamper consensus building, create conflict, and hinder progress.
Table 7.3 How to Block Teamwork [34]
Blocking Strategy Tactics
Dominate Talk as much as possible; interrupt and interject
Overanalyze Split hairs and belabor every detail
Stall Frustrate efforts to come to conclusions: decline to agree, sidetrack the discussion, rehash old ideas
Remain passive Stay on the fringe; keep interaction to a minimum; wait for others to take on work
Overgeneralize Blow things out of proportion; float unfounded conclusions
Find fault Criticize and withhold credit whenever possible
Make premature decisions Rush to conclusions before goals are set, information is shared, or problems are clarified
Present opinions as facts Refuse to seek factual support for ideas that you personally favor
Reject Object to ideas offered by people who tend to disagree with you
Pull rank Use status or title to push through ideas, rather than seek consensus on their value
Resist Throw up roadblocks to progress; look on the negative side
Deflect Refuse to stay on topic; focus on minor points rather than main points
As we highlighted earlier, throughout your academic career you’ll likely participate in a number of team projects. Not only will you make lasting friends by being a member of a team, but in addition you’ll produce a better product. To get insider advice on how to survive team projects in college (and perhaps really enjoy yourself in the process), let’s look at some suggestions offered by two students who have gone through this experience.[35][36]
• Draw up a team charter. At the beginning of the project, draw up a team charter (or contract) that includes the goals of the group; ways to ensure that each team member’s ideas are considered and respected; when and where your group will meet; what happens if a team member skips meetings or doesn’t do his or her share of the work; how conflicts will be resolved.
• Contribute your ideas. Share your ideas with your group; they might be valuable to the group. The worst that could happen is that they won’t be used (which is what would happen if you kept quiet).
• Never miss a meeting. Pick a weekly meeting time and write it into your schedule as if it were a class. Never skip it. And make your meetings productive.
• Be considerate of each other. Be patient, listen to everyone, communicate frequently, involve everyone in decision making, don’t think you’re always right, be positive, avoid infighting, build trust.
• Create a process for resolving conflict. Do this before conflict arises. Set up rules to help the group decide whether the conflict is constructive, whether it’s personal, or whether it arises because someone won’t pull his or her weight. Decide, as a group, how conflict will be handled.
• Use the strengths of each team member. Some students are good researchers, others are good writers, others have strong problem-solving or computer skills, while others are good at generating ideas. Don’t have your writer do the research and your researcher do the writing. Not only would the team not be using its resources wisely, but two team members will be frustrated because they’re not using their strengths.
• Don’t do all the work yourself. Work with your team to get the work done. The project output is not as important as the experience of working in a team.
• Set deadlines. Don’t leave everything to the end; divide up tasks, hold team members accountable, and set intermediary deadlines for each team member to get his or her work done. Work together to be sure the project is in on time and in good shape.
What Does It Take to Lead a Team?
“Some people are born leaders, some achieve leadership, and some have leadership thrust upon them.” Or so Shakespeare might have said if he were managing a twenty-first-century work team instead of a sixteenth-century theater troupe. At some point in a successful career, whether in business, school, or any other form of organizational work, you may be asked (or assigned) to lead a team. The more successful you are, the more likely you are to receive such an invitation. So, what will you have to do as a leader? What skills will you need?
Like so many of the questions that we ask in this book, these questions don’t have any simple answers. As for the first question—what does a leader have to do?—we can provide one broad answer: A leader must help members develop the attitudes and behavior that contribute to team success: interdependence, collective responsibility, shared commitment, and so forth.
Influence Team Members and Gain their Trust
Team leaders must be able to influence their team members. And notice that we say influence: except in unusual circumstances, giving commands and controlling everything directly doesn’t work very well.[37] As one team of researchers puts it, team leaders are more effective when they work with members rather than on them.[38] Hand in hand with the ability to influence is the ability to gain and keep the trust of team members. People aren’t likely to be influenced by a leader whom they perceive as dishonest or selfishly motivated.
Figure 7.4 Team Leaders
Team leaders are most effective when they can not only influence members but also gain their trust. [39]
Assuming you were asked to lead a team, there are certain leadership skills and behaviors that would help you influence your team members and build trust. Let’s look at seven of these:
• Demonstrate integrity. Do what you say you’ll do, and act in accordance with your stated values. Be honest in communicating with members, and follow through on promises.
• Be clear and consistent. Let members know that you’re certain about what you want, and remember that being clear and consistent reinforces your credibility.
• Generate positive energy. Be optimistic and compliment team members. Recognize their progress and success.
• Acknowledge common points of view. Even if you’re about to propose some kind of change, before embarking on a new stage of a project recognize the value of the views that members already hold in common.
• Manage agreement and disagreement. When members agree with you, focus on your point of view and present it reasonably. When they disagree with you, acknowledge both sides of the issue and support your own with strong, clearly presented evidence.
• Encourage and coach. Buoy up members when they run into new and uncertain situations and when success depends on their performing at a high level. Give them the information they need and otherwise help them to perform tasks.
• Share information. Let members know that you’re knowledgeable about team tasks and individual talents. Check with team members regularly to find out what they’re doing and how the job is progressing. Collect information from outside sources, and make sure that it gets to the team members who need it.
Key Takeaways
• As the business world depends more and more on teamwork, it’s increasingly important for incoming members of the workforce to develop skills and experience in team-based activities.
• Every team requires some mixture of three skill sets:
1. Technical skills: skills needed to perform specific tasks
2. Decision-making and problem-solving skills: skills needed to identify problems, evaluate alternative solutions, and decide on the best options
3. Interpersonal skills: skills in listening, providing feedback, and resolving conflict
• Team members deal with two basic challenges: (1) accomplishing the team’s assigned task and (2) maintaining or improving group cohesiveness.
• Task-facilitating roles address challenge number one—accomplishing team tasks. Relationship-building roles address challenge number two—maintaining or improving group cohesiveness. Blocking roles consist of behavior that inhibits either team performance or that of individual members.
• The following are eight ways to add value to and survive team projects in college:
1. Draw up a team charter.
2. Contribute your ideas.
3. Never miss a meeting.
4. Be considerate of each other.
5. Create a process for resolving conflict.
6. Use the strengths of each team member.
7. Don’t do all the work yourself.
8. Set deadlines.
• The following are seven types of skills and behaviors that help team leaders influence their members and gain their trust:
1. Demonstrating integrity
2. Being clear and consistent
3. Generating positive energy
4. Acknowledging common points of view
5. Managing agreement and disagreement
6. Encouraging and coaching
7. Sharing information
Exercise
(AACSB) Analysis
One student, a veteran of team-based assignments, has some good advice to offer students who are following in her footsteps. Don’t start, she advises, until you’ve drawn up a team charter. This charter (or contract) should include the following: the goals of the group; information on meeting times and places; ways to ensure that each member’s ideas are considered and respected; methods for resolving conflicts; a “kick-out” clause—a statement of what will happen if a team member skips meetings or fails to do his or her share of the work.[40]
Now assume that you’ve just been assigned to a team in one of your classes. Prepare a first-draft charter in which you spell out rules of conduct for the team and its members.
The Business of Communication
Learning Objectives
1. Discuss the role of communication in the design of the RAZR cell phone.
2. Define communication and discuss the ways in which organizations benefit from effective communication.
Communication by Design
As the chief designer assigned to the “thin-clam” team at Motorola, Chris Arnholt was responsible for some of the phone’s distinctive physical features, including its sleek aluminum finish and backlit keyboard. In fact, it was he who pushed the company’s engineers and marketers to buck an industry trend toward phones that were getting fatter because of many add-ons such as cameras and stereo speakers. For Arnholt had a vision. He called it “rich minimalism,” and his goal was to help the Motorola cell phone team realize a product that embodied that profile.
But what exactly did Arnholt mean by rich minimalism? “Sometimes,” he admits, “my ideas are tough to communicate,” but as a veteran in his field, he also understands that “design is really about communication”.[41][42] His chief (and ongoing) task, then, was communicating to the cell phone team what he meant by rich minimalism. Ultimately, of course, he had to show them what rich minimalism looked like when it appeared in tangible form in a fashionable new cell phone. In the process, he also had to be sure that the cell phone included certain key benefits that prospective consumers would want. As always, the physical design of the finished product had to be right for its intended market.
We’ll have much more to say about the process of developing new products in Chapter 10 “Product Design and Development”. Here, however, let’s simply highlight two points about the way successful companies approach the challenges of new-product design and development (which you will likely recognize from reading the first part of this chapter):
1. In contributing to the new-product design and development process, industrial designers like Chris Arnholt must effectively communicate both ideas and practical specifications.
2. The design and development process usually succeeds only when the assigned team integrates input from every relevant area of the organization.[43]
The common denominator in both facets of the process is effective communication. The designer, for example, must communicate not only his vision of the product but also certain specifications for turning it into something concrete. Chris Arnholt sculpted models out of cornstarch and then took them home at night to refashion them according to suggestions made by the product team. Then he’d put his newest ideas on paper and hand the drawings over to another member of his design team, who’d turn them into 3D computer graphics from which other specialists would build plastic models. Without effective communication at every step in this process, it isn’t likely that a group of people with different skills would produce plastic models bearing a practical resemblance to Arnholt’s original drawings. On top of everything else, Arnholt’s responsibility as chief designer required him to communicate his ideas not only about the product’s visual and physical features but also about the production processes and manufacturing requirements for building it.[44]
Thus Arnholt’s job—which is to say, his responsibility on the cell phone team—meant that he had to do a lot more than merely design the product. Strictly speaking, the designer’s function is to understand a product from the consumer’s point of view; develop this understanding into a set of ideas and specifications that will satisfy not only consumer needs but producer requirements; and make recommendations through drawings, models, and verbal communications (IDSA, 2008). Even our condensed version of the RAZR story, however, indicates that Arnholt’s job was far broader. Why? Because new-product design is an integrative process: contributions must come from all functions within an organization, including operations (which includes research and development, engineering and manufacturing), marketing, management, finance, and accounting.[45]
Our version of the RAZR story has emphasized operations (which includes research and development, engineering, and manufacturing) and touched on the role of marketing (which collects data about consumer needs). Remember, though, that members from several areas of management were recruited for the team. Because the project required considerable investment of Motorola’s capital, finance was certainly involved, and the decision to increase production in late 2004 was based on numbers crunched by the accounting department. At every step, Arnholt’s drawings, specs, and recommendations reflected his collaboration with people from all these functional areas.
Figure 7.5 Motorola Razor
The explosion of text messaging has changed the way people use their cell phones and created new design needs for manufacturers like Motorola. [46]
What all this interactivity amounts to is communication.[47] As for what Arnholt meant by rich minimalism, you’ll need to take a look at the picture of the RAZR at the beginning of the chapter. Among other things, it means a blue electroluminescent panel and a 22 kHz polyphonic speaker.
What Is Communication?
Let’s start with a basic (and quite practical) definition of communication as the process of transferring information from a sender to a receiver. When you call up a classmate to inform him that your Introduction to Financial Accounting class has been canceled, you’re sending information and your classmate is receiving it. When you go to your professor’s Web site to find out the assignment for the next class, your professor is sending information and you’re receiving it. When your boss e-mails you the data you need to complete a sales report and tells you to e-mail the report back to her by 4 o’clock, your boss is sending information and, once again, you’re receiving it; later in the day, the situation will be reversed.
Your Ticket In (or Out)
Obviously, you participate in dozens of “informational transfers” every day. (In fact, they take up about 70 percent of your waking hours—80 percent if you have some sort of managerial position.[48][49] In any case, it wouldn’t make much sense for us to pursue the topic much further without assuming that you’ve gained some experience and mastered some skills in the task of communicating. At the same time, though, we’ll also venture to guess that you’re much more comfortable having casual conversations with friends than writing class assignments or giving speeches in front of classmates. That’s why we’re going to resort to the same plain terms that we used when we discussed the likelihood of your needing teamwork skills in an organizational setting: The question is not whether you’ll need communication skills (both written and verbal). You will. The question is whether you’ll develop the skills to communicate effectively in a variety of organizational situations.
Once again, the numbers back us up. In a recent survey by the Association of Colleges and Employers, the ability to communicate well topped the list of skills that business recruiters want in potential hires.[50] A College Board survey of 120 major U.S. companies concludes that writing is a “threshold skill” for both employment and promotion. “In most cases,” volunteered one human resources director, “writing ability could be your ticket in—or your ticket out.” Applicants and employees who can’t write and communicate clearly, says the final report, “will not be hired and are unlikely to last long enough to be considered for promotion”.[51]
Why Are Communication Skills Important?
They’re important to you because they’re important to prospective employers. And why do employers consider communication skills so important? Because they’re good for business. Research shows that businesses benefit in several ways when they’re able to foster effective communication among employees:[52][53]
• Decisions are more convincing and certain, and problem solving is faster.
• Warning signs of potential problems appear earlier.
• Workflow moves more smoothly and productivity increases.
• Business relationships are stronger.
• Marketing messages are more persuasive.
• The company’s professional image is enhanced.
• Employee satisfaction goes up and turnover goes down.
• The firm and its investors enjoy better financial results.
What Skills Are Important?
Figure 7.6 “Required Skills” reveals some further findings of the College Board survey that we mentioned previously—namely, the percentage of companies that identified certain communication skills as being “frequently” or “almost always” necessary in their workplaces. As you can see, ability in using e-mail is a nearly universal requirement (and in many cases this includes the ability to adapt messages to different receivers or compose persuasive messages when necessary). The ability to make presentations (with visuals) also ranks highly.
Key Takeaways
• Effective communication is needed in several facets of the new-product design and development process:
1. Designers must effectively communicate both ideas and practical specifications.
2. The process usually succeeds only when the assigned team integrates input from every relevant area of the organization.
• Communication is the process of transferring information from a sender to a receiver.
• Businesses benefit in several ways when they’re able to foster effective communication among employees:
1. Decisions are more assured and cogent, and problem solving is faster.
2. Warning signs of potential problems appear earlier.
3. Workflow moves more smoothly and productivity increases.
4. Business relationships are stronger.
5. Marketing messages are more persuasive.
6. The company’s professional image is enhanced.
7. Employee satisfaction goes up and turnover goes down.
8. The firm and its investors enjoy better financial results.
Exercise
(AACSB) Analysis
Pick a company you’re interested in working for when you graduate from college. For this company, identify the following:
1. A starting position you’d like to obtain on graduation
2. A higher-level position you’d like to be promoted to in five years.
For each of these positions, describe the skills needed to get the job and those needed to be successful in the position.
Communication Channels
Learning Objectives
1. Discuss the nature of communications in an organizational setting, including communication flows, channels, and networks.
2. Explain barriers to communication, and discuss the most common types of barriers to group communication.
What Is Organizational Communication?
Clearly, the task of preparing and submitting a finished sales report doesn’t require the same kinds of communication skills as talking on the phone with a classmate. No matter what your “workstation” happens to be—whether your workplace office or your kitchen table—you’re performing the task of preparing that sales report in an organizational setting. You’re still a sender transferring information to a receiver, but the organizational context of the task requires you to consider different factors for success in communicating effectively (including barriers to success). A report, for example, must be targeted for someone in a specific position and must contain the information necessary to make a specific set of decisions.[54]
Communication Flows
Here’s another way of thinking about communication in an organizational setting. Let’s assume that you and the classmate you called on the phone are on roughly equal footing—you’re both juniors, your grades in the class are about the same, and so forth. Your phone conversation, therefore, is “lateral”: You belong to the same group (your accounting class), and your group activities take place on the same level.
Communication may also flow laterally in organizational settings (as it does between you and your classmate), but more often it flows up or down. Take a look at Figure 7.7 “Formal Communication Flows”. As you can see, we’ve added a few lines to show the three directions in which communications can flow in a typical organization:[55]:
• As the term suggests, downward communication flows from higher organizational levels (supervisors) to lower organizational levels (subordinates).
• Upward communication flows from lower to higher organizational levels.
• Lateral (or horizontal) communication flows across the organization, among personnel on the same level.
Your boss’s request for a sales report is an instance of downward communication, and when you’ve finished and submitted it, you will have completed a task of upward communication.
Advantages of Communication Flows
Naturally, each of these different directional flows has its functions and advantages. Downward communication, for example, is appropriate for giving instructions or directions—telling people what to do. (As a goal of communication, by the way, giving orders isn’t as one-sided as it may seem. One of the things that employees—the receivers—most want to know is: What, exactly, does my job entail?)[56] Like a sales report, upward communication usually provides managers with information that they need for making decisions, but it’s also the vehicle for new ideas, suggestions, and complaints. Horizontal communication supports efforts to coordinate tasks and otherwise help people work together.
Disadvantages of Communication Flows
And, of course, each type of flow has its disadvantages. As information seeps downward, for instance, it tends to lose some of its original clarity and often becomes distorted or downright wrong. (This is especially true when it’s delivered orally.) In addition, unlike Donald Trump, most people who are responsible for using downward communication don’t like delivering bad news (such as “You’re fired” or, more commonly, “Your job is being phased out”); as a result, bad news—including bad news that happens to be important news—is often ignored or disguised. The same thing may happen when bad news—say, a negative status report—must be sent upward.
Finally, while horizontal flows are valuable for promoting cooperation, they can also be used to engage in conflict—for instance, between two departments competing for the same organizational resources. The problem is especially bad when such horizontal communications breach official upward or downward lines of communication, thus bypassing managers who might be able to resolve the conflict.
Channels of Communication
Figure 7.8 “Channels of Communication” summarizes two additional sets of characteristics of organizational communication—internal and external channels and formal and informal channels.[57] Internal communication is shared by people at all levels within a company. External communication occurs between parties inside a company and parties outside the company, such as suppliers, customers, and investors. Both internal and external forms of communication include everything from formal e-mail and official reports to face-to-face conversations and casual phone calls. External communication also takes such forms as customer and supplier Web sites, news releases, and advertising.
FORMAL Planned communications following the company’s chain of command among people inside the organizatione-mail, memos, conference calls, reports, presentations, executive blogs Planned communications with people outside the organizationletters, instant messages, reports, speeches, news releases, advertising, Web sites executive blogs
INFORMAL Casual communications among employees that do not follow the company’s chain of commande-mail, instant messages, phone calls, face-to-face conversations, team blogs Casual communications with outsiders (e.g., suppliers, customers, investors)e-mail, instant messages, phone calls, face-to-face conversations, customer-support blogs
Note that Figure 7.8 “Channels of Communication” takes the form of a grid, thus creating four dimensions in which communication can take place. Informal communication, for example, can take place either among people within the company (internally) or between insiders and outsiders (externally). By and large, though you can use the same set of tools (memos, reports, phone calls) to communicate in any of these four situations, some tools (team blogs, news releases, supplier Web sites) are useful only in one or two.
The Formal Communication Network
An organization’s formal communication network consists of all communications that flow along its official lines of authority. Look again at Figure 7.7 “Formal Communication Flows”. Because it incorporates the organization chart for Notes-4-You, it shows the company’s lines of authority—what we called reporting relationships. Here we can see that the reporting relationships in question consist of upward communication from subordinates to superiors. In reporting to the operations manager, for example, the notetakers’ supervisor communicates upward. Conversely, when the notetakers’ manager needs to give direction to notetakers, she will use downward communication. If the notetakers’ manager and the copiers’ manager must get together to prepare a joint report for the operations manager, they’ll engage in lateral communication. In short, an organization’s formal communication network is basically the same thing as its network of reporting relationships and lines of authority.[58]
The Informal Communication Network
Every company also has an informal communication network (or grapevine), which goes to work whenever two or more employees get together and start talking about the company and their jobs. Informal communication can take place just about anywhere (in one person’s cubicle, in the cafeteria, on the golf course) and by just about any means (phone, e-mail, instant messaging, face-to-face conversation).
Though it’s sometimes called the grapevine, an informal network is an extremely important communication channel. Why? For the simple reason that it’s typically widespread and can rarely be prevented, even if it’s not officially sanctioned by the company—indeed, even when the company tries to discourage or bypass it. Unofficial information crosses virtually every boundary drawn by a firm’s organization chart, reaching out and touching everyone in the organization, and what’s more, it travels a lot faster than official information.
Problems with the Flow of Information through Informal Channels
The downside of “unofficial” information should be obvious. Because much of it is communicated orally, it’s likely to get distorted and often degenerates into outright misinformation. Say, for example, that a rumor about layoffs gets started in your workplace. As more than one manager will verify, such rumors can do more damage than the reality. Morale may plummet and productivity won’t be far behind. Valuable employees may abandon ship (needlessly, if the rumors are false).[59]
And imagine what can happen if informal information gets outside the organization. In the 1970s, Chicago-area McDonald’s outlets found themselves fighting rumors about worms in their hamburgers. Over the years, Coca-Cola has had to fight rumors about terrorists joining its organization, subversive messages concealed in its label, and hyperacidity (false rumors that Coke causes osteoporosis and makes a good pesticide and an equally good spermicide).[60][61]
What to Do about Informal Information Flows
On the upside, savvy managers can tap into the informal network, either to find out what sort of information is influencing employee activities or to circulate more meaningful information, including new ideas as well as corrective information. In any case, managers have to deal with the grapevine, and one manager has compiled a list of suggestions for doing so effectively:[62]
• Learn to live with it. It’s here to stay.
• Tune into it. Pay attention to the information that’s circulating and try to learn something from it. Remember: The more you know about grapevine information, the better you can interact with employees (who, in turn, will probably come to regard you as someone who keeps in touch with the things that concern them).
• Don’t participate in rumors. Resist the temptation to add your two cents’ worth, and don’t make matters worse.
• Check out what you hear. Because it’s your job to replace bad information with good information, you need to find out what’s really going on.
• Take advantage of the grapevine. Its only function is to carry information, so there’s no reason why you can’t pump some useful information through it.
Perhaps most importantly, when alert managers notice that the grapevine is particularly active, they tend to reach a sensible twofold conclusion:
1. The organization’s formal lines of communication aren’t working as well as they should be.
2. The best way to minimize informal communication and its potential damage is to provide better formal communication from the outset—or, failing that, to provide whatever formal communication will counteract misinformation as thoroughly as possible.
Let’s go back to our example of a workplace overwhelmed by layoff rumors. In a practical sense, what can a manager—say, the leader of a long-term product-development team—do to provide better communication? One manager suggests at least three specific responses:[63]
1. Go to your supervisor or another senior manager and try to find out as much as you can about the organization’s real plans.
2. Ask a senior manager or a human resources representative to meet with your team and address members’ concerns with accurate feedback.
3. Make it a priority to keep channels open—both between yourself and your team members and between team members and the human resources department.
Because actions of this sort send a message, they can legitimately be characterized as a form of formal communication. They also reflect good leadership: Even though the information in this case relates only indirectly to immediate team tasks, you’re sharing information with people who need it, and you’re demonstrating integrity (you’re being honest, and you’re following through on a commitment to the team).
Overcoming Barriers to Communication
What Are Barriers to Communication?
By barriers we mean anything that prevents people from communicating as effectively as possible. Noise, for example, can be a barrier to communication; if you and other team members are mumbling among yourselves while your team leader is trying to explain task assignments, you’re putting up a barrier to group communication. As a matter of fact, you’re putting up two barriers: In addition to creating noise, you’re failing to listen. About 80 percent of top executives say that learning to listen is the most important skill in getting things done in the workplace,[64][65] and as President Calvin Coolidge once remarked, “No man ever listened himself out of a job.” Business people who don’t listen risk offending others or misinterpreting what they’re saying.
Two Types of Barriers
Figure 7.9 Barriers to Communication
Though developed to improve communication, in some cases cell phones can create a barrier. [66]
As for creating unnecessary verbal noise and failing to listen, we can probably chalk them up to poor communication habits (or maybe the same habit, for as legendary management expert Peter Drucker argues, “Listening is not a skill; it is a discipline. All you have to do is keep your mouth shut”). In the rest of this section, we’ll overlook personal barriers to communication and concentrate instead on two types of barriers that are encountered by groups of people, sometimes large and sometimes small, working toward organizational goals.
Cultural Barriers
Cultural barriers, which are sometimes called cultural filters, are the barriers that result from differences among people of different cultures.[67] Experts and managers agree that cultural diversity in the workplace can and should be a significant asset: It broadens the perspectives from which groups approach problems, gives them fresh ideas, and sparks their creativity; it also gives organizations an advantage in connecting with diverse customer bases. None of these advantages, though, magically appears simply because workplace diversity increases. To the contrary: As diversity increases, so does the possibility that a group will be composed of people who have different attitudes and different ways of expressing them.
If it hasn’t happened already, for example, one of these days you’ll find yourself having a work-related conversation with a member of the opposite sex. If the conversation doesn’t go as smoothly as you’d expected, there’s a good reason: Men and women in the workplace don’t communicate the same way. According to American linguist Deborah Tannen, men tend to assert their status, to exert confidence, and to regard asking questions as a sign of weakness. Women, in contrast, tend to foster positive interrelationships, to restrain expressions of confidence, and to ask questions with no trouble.[68][69]
It really doesn’t matter which “style” (if either) is better suited to making a conversation more productive. Two points, however, are clear:
1. Even if two people of the opposite sex enter a conversation with virtually identical viewpoints, their different styles of expressing themselves might very well present a barrier to their reaching an agreement. Much the same can be said of differences in style arising from other cultural filters, such as ethnicity, education, age, and experience.
2. Workplace conversations can be tricky to negotiate, yet there’s no escaping them. Like life in the outside world, observes Tannen, life in the workplace “is a matter of dealing with people…and that means a series of conversations.” That’s also why surveys continue to show that managers regard the ability to communicate face to face as a key factor in an employee’s promotability.[70]
Functional Barriers
Let’s return for a moment to Figure 7.7 “Formal Communication Flows”. Recall that when we introduced the organizational structure, we characterized it as a functional organization—one that groups together people who have comparable skills and perform similar tasks. Note, however, that in setting up this form of organization for our hypothetical company, we found it necessary to insert two layers of management (four functional managers and two job supervisors) between our owner/president and our lowest-level employees. In this respect, our structure shares certain characteristics with another form of organization—divisional, which groups people into units that are more or less self-contained and that are largely accountable for their own performance.
What does all this have to do with barriers to communication? Simply this: The more “divisionalized” an organization becomes, the more likely it will be to encounter communication barriers. Not surprisingly, communication gets more complicated, for the same reason that an organization comes to rely on more levels of management.[71] Notes-4-You, for instance, needs two supervisors because its notetakers don’t do the same work as its copiers. In addition, because their groups don’t perform the same work, the two supervisors don’t call on the same resources from the company’s four functional managers. (Likewise, Notes-4-You also has four functional-area managers because none of them does the same work as any of the others.)
Officially, then, the operations of the two work groups remain distinct or specialized. At the same time, each group must contribute to the company-wide effort to achieve common goals. Moreover, certain organizational projects, like Motorola’s cell phone project, may require the two groups to work together more closely than usual. When that happens, employees from each of the two groups may find themselves working together on the same team, but even so, one crucial fact remains: Information that one group possesses and the other doesn’t must still be exchanged among team members. It may not be quite as apparent as the cultural diversity among men and women in many workplace situations, but there is in fact a functional diversity at Notes-4-You among notetakers and copiers.[72]
Figure 7.10 “Functional Barriers to Communication” illustrates the location of barriers that may be present when a team-based project must deal with a certain degree of functional diversity. As you can see, we’ve modeled our process on the process of the Motorola ultratrim phone project.[73] We don’t need to describe the entire process in detail, but we will focus on two aspects of it that we’ve highlighted in the drawing:
1. The company has assigned team members from different functional areas, notably marketing and operations (which, as at Motorola, includes design, engineering, and production).
2. Information (which we’ve characterized as different types of “specs”) must be transferred from function to function, and at the key points where this occurs, we’ve built in communication barriers (symbolized by brick walls).
If, for example, marketing specs called for the new Motorola phone to change colors with the user’s mood, someone in engineering might have to explain the difficulties in designing the software. If design specs called for quadraphonic sound, production might have to explain the difficulties in procuring sufficiently lightweight speaker components.
Figure 7.10 Functional Barriers to Communication
Each technical problem—each problem that arises because of differences in team members’ knowledge and expertise—becomes a problem in communication. In addition, communicating as a member of a team obviously requires much more than explaining the limitations of someone else’s professional expertise. Once they’ve surfaced, technical and other problems have to be resolved—a process that will inevitably require even more communication. As we’ve seen in this part of the chapter, improving communication is a top priority for most organizations (for one thing, developing a team-based environment is otherwise impossible), and the ongoing task of improving communication is pretty much the same thing as the ongoing task of overcoming barriers to it.
Key Takeaways
• In a typical organizational setting, communication flows may take three directions:
1. Downward communication flows from higher organizational levels (supervisors) to lower organizational levels (subordinates).
2. Upward communication flows from lower to higher organizational levels.
3. Lateral (or horizontal) communication flows across the organization, among personnel on the same level.
• Organizational communication flows through two different channels. Internal communication is shared by people at all levels within a company. External communication occurs between parties inside a company and parties outside the company, such as suppliers, customers, and investors.
• Organizational communication also flows through two different networks. Its formal communication network consists of all communications that flow along an organization’s official lines of authority. The informal communication network, sometimes called the grapevine, goes to work whenever two or more employees get together and start talking about the company and their jobs.
• Barriers to communication include anything that prevents people from communicating as effectively as possible. Among groups, two types of barriers are common. Cultural barriers, sometimes called cultural filters, are the barriers that result from differences among people of different cultures. Functional barriers arise when communication must flow among individuals or groups who work in different functional areas of an organization.
Exercise
(AACSB) Analysis
Write three messages (you decide which communication channel to use):
1. To a coworker asking her for a report on this quarter’s sales for your division
2. To your manager telling him what the sales were for the quarter and whether sales improved (or got worse), and why
3. To the vice president of the company recommending a new system for tracking sales in your division
Forms of Communication
Learning Objectives
1. Explain the do’s and don’ts of business e-mails.
2. Describe the process followed to create and deliver successful presentations.
3. Learn how to write clear, concise memos.
As mentioned previously, the College Board identified these communication skills as “frequently” or “almost always” necessary in the workplace:[74] e-mail, presentation with visuals, technical reports, formal reports, memos, and presentations without visuals. The skill ranked highest in importance was the use of e-mails, including the ability to adapt messages to different receivers or compose persuasive messages when necessary. The ability to make presentations (with visuals) ranked second in importance. Report writing came next. Given the complexity of report writing, we will not cover this topic here. Instead, we will look at the remaining three forms of communication: e-mail, presentations with visuals, and memos.
Tips for Writing Business E-Mails
Dennis Jerz and Jessica Bauer created the following list of the top 10 tips for writing effective e-mail messages:[75]
1. Write a meaningful subject line. Recipients use the subject line to decide whether to open or delete a message and sometimes where to store it. Write a subject line that describes the content.
2. Keep the message focused. Avoid including multiple messages or requests in one e-mail. Try to focus on only one topic. Use standard capitalization and spelling; none of this “thx 4 ur help 2day ur gr8.”
3. Avoid attachments. Extract the relevant text from a large file and ask the recipient if he or she wants to see the full document.
4. Identify yourself clearly. Identify yourself in the first few lines—otherwise your message might be deleted quickly.
5. Be kind. Don’t flame. Avoid writing e-mails when you are upset. Always think before you hit the “send” button. Once it’s gone, you can’t get it back. If you’re mad, write the e-mail, but don’t send it. Keep it in your “save” or “draft” folder and reread it the next day.
6. Proofread. Use spell check and read the memo carefully before sending it.
7. Don’t assume privacy. Don’t send anything you wouldn’t want posted on the office bulletin board (with your name on it). Remember, employers can read your e-mails!
8. Distinguish between formal and informal situations. When writing to a coworker with whom you are friends, you can be less formal than when you are writing to your manager or a client.
9. Respond promptly. Get back quickly to the person who sent you the e-mail. If you’re too busy to answer, let the person know you got the message and will respond as soon as you can.
10. Show respect and restraint. Watch out: Don’t use the “reply to all” button in error. Don’t forward an e-mail before getting permission from the sender.
Planning, Preparing, Practicing, and Presenting
For some, the thought of making a presentation is traumatic. If you’re one of those people, the best way to get over your fear is to get up and make a presentation. With time, it will get easier, and you might even start enjoying it. As you progress through college, you will have a number of opportunities to make presentations. This is good news—it gives you practice, lets you make your mistakes in a protected environment (before you hit the business world), and allows you to get fairly good at it. Your opportunities to talk in front of a group will multiply once you enter the business world. Throughout your business career, you’ll likely be called on to present reports, address groups at all levels in the organization, represent your company at various events, run committee meetings, lead teams, or make a sales pitch.[76] In preparing and delivering your presentation, you can follow a four-step process (plan, prepare, practice, and present) designed by Dale Carnegie, a global training company named after its famed founder.[77]
Plan
Plan your presentation based on your purpose and the knowledge level and interest of your audience. Use words and concepts your audience can understand, and stay focused. If your audience is knowledgeable about your topic, you can skim over the generalities and delve into the details. On the other hand, if the topic is new to them, you need to move through it slowly. As you plan your presentation, ask yourself these questions: What am I trying to accomplish? Am I trying to educate, inform, motivate, or persuade my audience? What does my audience know about the topic? What do I want them to know? How can I best convey this information to them?
Prepare
Once you have planned your presentation, you’re ready to prepare. It might be easier to write your presentation if you divide it into three sections: opening, body, close. Your opening should grab your audience’s attention. You can do this by asking a question, telling a relevant story, or even announcing a surprising piece of information. About 5 to 10 percent of your time can be spent on the opening. The body covers the bulk of the material and consumes about 80 to 85 percent of your time. Cover your key points, stay focused, but do not overload your audience. It has been found that an audience can absorb only about four to six points. Your close, which uses about 5 to 10 percent of your time, should leave the audience with a positive impression of you and your presentation. You have lots of choices for your close: You can either summarize your message or relate your closing remarks to your opening remarks or do both.
Practice
This section should really be called “Practice, Practice, Practice” (and maybe another Practice for emphasis). The saying “practice makes perfect” is definitely true with presentations, especially for beginners. You might want to start off practicing your presentation by yourself, perhaps in front of a mirror. You could even videotape yourself and play it back (that should be fun). As you get the hang of it, ask a friend or a group of friends to listen to and critique your talk. When you rehearse, check your time to see whether it’s what you want. Avoid memorizing your talk, but know it well.
Present
Figure 7.11 Presentations
Preparation is key to a successful presentation. [78]
Now you’re ready for the big day—it’s time to present. Dress for the part—if it’s a professional talk, dress like a professional. Go early to the location where you’ll present, check out the room, and be sure any equipment you’ll need is there and works. Try to connect with your audience as soon as you start your presentation. Take your time delivering your opening. Act as natural as you can, and try to relax. Slow your speech down, as you’ll likely have a tendency to speed up if you get nervous. Pause before and after your main point for emphasis. If you put brief notes on index cards, avoid reading from the cards. Glance down at them when needed, but then look up at your audience as you speak. Involve your audience in your presentation by asking them questions. Not only will they feel included, but it will help you relax. When you’re close to finishing, let your audience know this (but don’t announce it too early in the talk or your audience might start packing up prematurely). Remember to leave some time for questions and answers.
Visual Aids
It’s very common to use visual aids (generally PowerPoint slides) in business presentations. The use of visual aids helps your audience remember your main points and keeps you focused. If you do use PowerPoint slides, follow some simple (but important) rules:[79]
• Avoid wordiness: use key words and phrases only.
• Don’t crowd your slide: include at most four to five points per slide.
• Use at least an eighteen-point font (so that it can be seen from the back of the room).
• Use a color font that contrasts with the background (for example, blue font on white background).
• Use graphs rather than just words.
• Proof your slides and use spell check.
And most important: The PowerPoint slides are background, but you are the show. Avoid turning around and reading the slides. The audience wants to see you talk; they are not interested in seeing the back of your head.
How to Write an Effective Memo
Memos are effective at conveying fairly detailed information. To help you understand how to write a memo, read the following sample memorandum.
Memorandum
TO
FROM
DATE
RE
____________________________________________
As college students, you’ll be expected to analyze real-world situations, research issues, form opinions, and provide support for the conclusions that you reach. In addition to engaging in classroom discussions of business issues, you’ll be asked to complete a number of written assignments. For these assignments, we’ll give you a business situation and ask you to analyze the issues, form conclusions, and provide support for your opinions.
In each assignment, you’ll use the memo format, which is the typical form of written communication used in business. Writing in memo format means providing a complete but concise response to the issues at hand. Good memo writing demands time and effort. Because the business world expects you to possess this skill, we want to give you an opportunity to learn it now.
Guidelines
Here are a few helpful hints to get you started on the right track:
• The format should follow the format of this memo. Note the guide headings—“TO,” “FROM,” “DATE,” and “RE” (which, by the way, stands for “regarding” or “reference”). We also include a line across the page to signal the beginning of the body of the memo.
• Keep paragraphs short and to the point. The trick is being concise yet complete—summarizing effectively. Paragraphs should be single-spaced, flush against the left margin, and separated by a single blank line.
• Accent or highlight major points. Use underlining, bullets, or bold type for desired effect (taking care not to overdo it).
• Use short headings to distinguish and highlight vital information. Headings keep things organized, provide structure, and make for smooth reading. Headings (and, as appropriate, subheadings) are an absolute must.
• Your title (the “Re” line) should reflect the contents of your memo: It should let the reader know why he or she should read it. Keep the title short—a phrase of a few words, not a sentence.
• Be persuasive and convincing in your narrative. You have limited space in which to get your key points across. State your positions clearly. And again, be concise (a memo is not a term paper).
• If you have any additional information in the form of exhibits—charts, tables, illustrations, and so forth—put them in an attachment. Label each item “Exhibit 1,” “Exhibit 2,” and the like. Give each one a title, and be sure to reference them in your narrative (“As shown in Exhibit 1, the annual growth rate in sales has dropped from double-digit to single-digit levels”).
• Finally, staple multiple pages for submission. Needless to say, be sure to proofread for correct spelling and punctuation. Don’t scribble in changes by hand: They’re sloppy and leave a bad impression.
Final Comment
Now that you’ve read our memo, we expect you to follow the simple guidelines presented in it. This form of communication is widely practiced in business, so take advantage of this opportunity to practice your memo-writing skills.
Nonverbal Communication
Sometimes it’s not what you say or how you say it that matters, but what your body language communicates about you and how you feel. When a good friend who’s in a bad mood walks into a room, you don’t need to hear a word from her to know she’s having an awful day. You can read her expression. In doing this, you’re picking up on her nonverbal communication—“nonword” messages communicated through facial expressions, posture, gestures, and tone of voice. People give off nonverbal cues all the time. So what effect do these cues have in the business setting? Quite a bit—these cues are often better at telling you what’s on a person’s mind than what the person actually says. If an employee is meeting with his supervisor and frowns when she makes a statement, the supervisor will conclude that he disapproved of the statement (regardless of what he claims). If two employees are discussing a work-related problem and one starts to fidget, the other will pick this up as disinterest.
Given the possible negative effect that nonverbal cues can have in business situations, how can you improve your body language? The best approach is to become aware of any nonverbal cues you give out, and then work to eliminate them. For example, if you have a habit of frowning when you disapprove of something, recognize this and stop doing it. If the tone of your voice changes when you are angry, try to maintain your voice at a lower pitch.
Key Takeaways
• Here are ten tips for writing an e-mail:
1. Write a meaningful subject line.
2. Keep the message focused and readable.
3. Avoid attachments.
4. Identify yourself clearly in the first few lines.
5. Be kind. Don’t flame. Always think before hitting the “send” button.
6. Proofread.
7. Don’t assume privacy.
8. Distinguish between formal and informal situations.
9. Respond promptly.
10. Show respect and restraint.
• In preparing and delivering your presentation, you can follow a four-step process: plan, prepare, practice and present.
• You should plan your presentation based on your purpose and the knowledge level and interest of your audience.
• In preparing your presentation, it helps to divide it into three sections: opening, body and close.
1. Your opening, which uses about 5–10 percent of your time, should grab your audience’s attention.
2. The body covers your main points and uses about 80 to 85 percent of your time.
3. Your close, which uses about 5 to 10 percent of your time, should leave the audience with a positive impression of you and your presentation.
• The saying “practice makes perfect” is definitely true when giving presentations (especially for beginners).
• When you present, dress professionally, connect with your audience, try to relax and pause before and after your main points for emphasis.
1. Visual aids, such as PowerPoint slides, can aid your presentation if they are used properly.
• Memos are effective at conveying fairly detailed information. Here are some tips:
1. Keep paragraphs short and to the point.
2. Accent or highlight major points.
3. Use short headings.
4. Your title should reflect the contents of your memo.
5. Be persuasive and convincing in your narrative.
Exercise
(AACSB) Reflection
1. Ask a friend or a family member to tell you which nonverbal cues you frequently transmit. Identify those that would be detrimental to you in a business situation. Indicate how you could eliminate or reduce the impact of these cues. Ask the same person (or someone else) whether you are a good listener. If the answer is no, indicate how you could improve your listening skills.
2. Prepare a presentation on “planning, preparing, practicing, and presenting.” Divide your presentation into three parts: opening, body, and closing. Prepare visual aids. Pretend that your audience is made up of recent college graduates hired by Nike.
Cases and Problems
Learning on the Web (AACSB)
Factors Contributing to Nike’s Success
This writing assignment solicits your opinion on factors contributing to Nike’s success. To complete it, you should go to http://www.nikebiz.com/company_overview/timeline to learn about Nike’s history by reviewing the company’s time line.
Memo Format
Use the memo format described in the chapter for this assignment. Your memo should not exceed two pages. It should be single spaced (with an extra space between paragraphs and bulleted items).
Scenario
You’re one of the fortunate college students selected to participate in Nike’s summer internship program. The program is quite competitive, and you still can’t believe that you were chosen. You arrived in Beaverton, Oregon, yesterday morning and have been busy ever since. Last night, you attended a dinner for new interns where you were welcomed to Nike by CEO Mark Parker.
You were lucky to be sitting next to a personable, well-informed Nike veteran named Simon Pestridge. Pestridge joined Nike about twelve years ago. He was telling you about a past assignment he had as director of marketing for Australia. (You were impressed with his status at Nike, not just because he doesn’t look much older than you, but also because you’ve always wanted to travel to Australia.) The dinner conversation turned to a discussion of the reasons for Nike’s success. Others at the table were giving their opinions on the subject when Pestridge turned to you and said, “As a new intern, give us an outsider’s point of view. Why do you think Nike’s been so successful?” You were about to venture an opinion when Pestridge was called away for a phone call. As he got up, however, he quickly said, “Send me a memo telling me what factors you think have contributed to Nike’s success. Keep it simple. Three factors are plenty.” Though you were relieved to have a little time to think about your answer, you were also a bit nervous about the prospect of writing your first official memo.
As everyone else headed for the Bo Jackson gym, you went back to your room to think about Pestridge’s question and to figure out how to go about writing your memo. You want to be sure to start by telling him that you enjoyed talking with him. You also need to remind him that you’re responding to his question about three factors in Nike’s success, and must be sure to explain why you believe they’re important. You’ll end by saying that you hope the information is helpful and that he can contact you if he has any further questions.
So far, so good, but you’re still faced with the toughest part of your task—identifying the three factors that you deem important to Nike’s success. Fortunately, even at Nike there’s always tomorrow to get something done, so you decide to sleep on it and write your memo in the morning.
Ethics Angle (AACSB)
The Goof-Off
You and three other students have been working on a group project all semester in your Introduction to Business class. One of the members of the team did very little work; he failed to attend almost all the meetings, took no responsibility for any of the tasks, didn’t attend the practice session before your presentation, and in general was a real goof-off. But he happens to be friends with two of the team members. You and your other team members have been asked to complete the attached team member evaluation. You want to give the student what he deserves—almost no credit. But your other two team members don’t agree. They argue that it is “unsocial and mean” to tell the truth about this student’s lack of contribution. Instead, they want to report that everyone shared the work equally. The evaluation will be used in determining grades for each team member. Those who contributed more will get a higher grade than those who did not. Prepare an argument that you can advance to the other team members on the ethics of covering for this student. Assuming that your two teammates won’t change their minds, what would you do?
Attachment to Ethics Angle Problem
Introduction to Business
Team Member Evaluation
(To be given to your faculty member during the last week of class)
TEAM ___________________
You have a total of \$100,000. You can use this to reward your team members (including yourself) for their contributions to the team project.
Fill in each team member’s name below (including your own), and show beside each name how much of the \$100,000 you would give that member for his or her contributions to the preparation and presentation of the team project. Do not share your recommendations with your team members.
Your recommendations will be confidential.
Team Members (including yourself) Amount to be given for efforts on team project
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
TOTAL (MUST EQUAL \$100,000) \$_________________________
YOUR NAME ______________________________________________________
Team-Building Skills (AACSB)
Team Skills and Talents
Team projects involve a number of tasks that are handled by individual team members. These tasks should be assigned to team members based on their particular skills and talents. The next time you work on a team project, you should use the following table to help your team organize its tasks and hold its members responsible for their completion.
Here is how you should use this document:
1. Identify all tasks to be completed.
2. Assign each task to a member (or members) of your team based on their skills, talents, and time available.
3. Determine a due date for each task.
4. As a task is completed, indicate its completion date and the team member (or members) who completed the task. If more than one team member works on the assignment, indicate the percentage of time each devoted to the task. You can add tasks that surface as your team works its way through the project.
5. If the assigned person fails to complete the task, or submits poor quality work, add a note to the report explaining what happened and how the situation was corrected (for example, another team member had to redo the task).
6. Submit the completed form (with all columns completed) to your faculty member at the class after your team project is due. Include a cover sheet with your team’s name (or number) and the name of each team member.
Tasks to Be Completed Initials of Team Member(s) Who Will Complete Task Date to Be Completed Date Completed Initials of Team Member(s) Who Completed Task (Add a Note Below the Table Explaining Any Problems with Completion or Quality of Work)
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________
The Global View (AACSB)
A Multicultural Virtual Team
You work for Nike, a global company. You just learned that you were assigned to a virtual team whose mission is to assess the feasibility of Nike’s making an inexpensive shoe that can be sold in Brazil. The team consists of twelve members. Three of the members work in the United States (two in Beaverton, Oregon, and one in New York City). Two work in England, two in China, two in India, and three in Brazil. All are Nike employees and all were born in the country in which they work. All speak English, though some speak it better than others. What challenges do you anticipate the team will face because of its multicultural makeup?. How could these challenges be overco
1. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 4.
2. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 4.
3. Alderfer, C. P., “Group and Intergroup Relations,” in Improving Life at Work, ed. J. R. Hackman and J. L. Suttle (Palisades, CA: Goodyear, 1977), 277–96.
4. Fisher, K., Leading Self-Directed Work Teams: A Guide to Developing New Team Leadership Skills, rev. ed. (New York: McGraw-Hill Professional, 1999).
5. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 315–16.
6. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 315–16.
7. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 4.
8. Source: Adapted from Edward E. Lawler, S. A. Mohman, and G. E. Ledford, Creating High Performance Organizations: Practices and Results of Employee Involvement and Total Quality in Fortune 1000 Companies (San Francisco: Wiley, 1992). Reprinted with permission of John Wiley & Sons Inc.
9. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 4.
10. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 4.
11. Fishman, C., “Whole Foods Is All Teams,” Fast Company.com, December 18, 2007, http://www.fastcompany.com/node/26671/print (accessed October 11, 2011).
12. Human Technology Inc., “Organizational Learning Strategies: Cross-Functional Teams,” Getting Results through Learning, http://www.humtech.com/opm/grtl/ols/ols3.cfm (accessed October 11, 2011).
13. Robbins, S. P., and Timothy A. Judge, Organizational Behavior, 13th ed. (Upper Saddle River, NJ: Pearson Education, 2009), 340–42.
14. George, J. M., and Gareth R. Jones, Understanding and Managing Organizational Behavior, 5th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 381–82.
15. Adept Science, “Lockheed Martin Chooses Mathcad as a Standard Design Package for F-35 Joint Strike Fighter Project,” Adept Science, September 23, 2003, http://www.adeptscience.co.uk/pressroom/article/96 (accessed October 11, 2011).
16. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 497.
17. George, J. M., and Gareth R. Jones, Understanding and Managing Organizational Behavior, 5th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 371–77.
18. Festinger, L., “Informal Social Communication, Psychological Review 57 (1950): 271–82.
19. Griffin, E., “Groupthink of Irving Janis,” 1997, http://www.doh.state.fl.us/alternatesites/cms-kids/providers/early_steps/training/documents/groupthink_irving_janus.pdf (accessed October 11, 2011).
20. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 317–18.
21. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 323–24.
22. Thompson, L. L., Making the Team: A Guide for Managers (Upper Saddle River, NJ: Pearson Education, 2008), 323–24.
23. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
24. Wellins, R. S., William C. Byham, and Jeanne M. Wilson, Empowered Teams (San Francisco: Jossey-Bass, 1991).
25. Nichols, H., “Teamwork in School, Work and Life,” iamnext.com, 2003, http://www.iamnext.com/academics/groupwork.html (accessed September 1, 2008).
26. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
27. Lawler, E. E., Treat People Right (San Francisco: Jossey-Bass, 2003).
28. Paulson, T. L., “Building Bridges vs. Burning Them: The Subtle Art of Influence,” 1990, at http://books.google.com/books?id=iXkq-IFFJpcC&pg=PA55&lpg=PA55&dq=%22capable+people+fail+to+ advance%22&source=web&ots=a2l2cJ2_AF&sig=4Xk7EuOq2htSf2XqBWSFQxJwVqE &hl=en&sa=X&oi=book_result&resnum=1&ct=result (accessed September 2, 2008).
29. Fortune Magazine, “What Makes Great Leaders: Rethinking the Route to Effective Leadership,” Findings from the Fortune Magazine/Hay Group 1999 Executive Survey of Leadership Effectiveness, http://ei.haygroup.com/downloads/pdf/Leadership%20White%20Paper.pdf (accessed August 9, 2008).
30. Robbins, S. P., and Timothy A. Judge, Organizational Behavior, 13th ed. (Upper Saddle River, NJ: Pearson Education, 2009), 346–47.
31. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
32. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
33. Source: Adapted from David A. Whetten and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 517, 519.
34. Source: Adapted from David A. Whetten and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 519–20.
35. Nichols, H., “Teamwork in School, Work and Life,” iamnext.com, 2003, http://www.iamnext.com/academics/groupwork.html (accessed September 1, 2008).
36. Feenstra, K., “Study Skills: Team Work Skills for Group Projects,” iamnext.com, 2002, http://www.iamnext.com/academics/grouproject.html (accessed October 11, 2011).
37. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
38. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 498–99.
39. Pixabay – CC0 Public Domain.
40. Feenstra, K., “Study Skills: Team Work Skills for Group Projects,” iamnext.com, 2002, http://www.iamnext.com/academics/grouproject.html (accessed October 11, 2011).
41. Lashinsky, A., “RAZR’s Edge,” Fortune, CNNMoney.com, June 1, 2006, http://money.cnn.com/magazines/fortune/fortune_archive/2006/06/12/8379239/index.htm (accessed August 22, 2008)
42. Anthony, S. D., “Motorola’s Bet on the RAZR’s Edge,” HBS Working Knowledge, September 12, 2005, http://hbswk.hbs.edu/archive/4992.html (accessed October 11, 2011).
43. Urban, G. L., and John R. Hauser, Design and Marketing of New Products, 2nd ed. (Upper Saddle River, NJ: Prentice Hall, 1993), 173.
44. (ISDA) Industrial Designers Society of America (IDSA), “About ID,” IDSA, http://www.idsa.org/absolutenm/templates/?a=89&z=23 (accessed September 4, 2008).
45. Urban, G. L., and John R. Hauser, Design and Marketing of New Products, 2nd ed. (Upper Saddle River, NJ: Prentice Hall, 1993), 173.
46. Adrian Black – Motorola V3i Open – CC BY-NC 2.0.
47. Urban, G. L., and John R. Hauser, Design and Marketing of New Products, 2nd ed. (Upper Saddle River, NJ: Prentice Hall, 1993), 173.
48. Robbins, S. P., and Timothy A. Judge, Organizational Behavior, 13th ed. (Upper Saddle River, NJ: Pearson Education, 2009), 368.
49. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 243.
50. National Association of Colleges and Employers, “2006 Job Outlook,” NACEWeb, 2007, http://www.naceweb.org (accessed October 11, 2011).
51. College Board, “Writing: A Ticket to Work…or a Ticket Out: A Survey of Business Leaders,” Report of the National Commission on Writing, September 2004, http://www.writingcommission.org/prod_downloads/writingcom/writing-ticket-to-work.pdf (accessed October 11, 2011).
52. Thill, J. V., and Courtland L. Bovée, Excellence in Business Communication, 8th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 4.
53. Carr, N., “Lessons in Corporate Blogging,” Business Week, July 18, 2006, 9.
54. Netzley, M., and Craig Snow, Guide to Report Writing (Upper Saddle River, NJ: Prentice Hall, 2002), 3–21.
55. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 351–53.
56. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 351–53.
57. Thill, J. V., and Courtland L. Bovée, Excellence in Business Communication, 8th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 4–6.
58. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 351–53.
59. Watson, S. A., “Sharing Info and Defusing Rumors Helps Keep Staff Motivated During Layoffs,” ZDNet, July 29, 2003, http://www.zdnetasia.com/sharing-info-and-defusing-rumors-helps-keep-staff-motivated-during-layoffs-39140816.htm (accessed October 11, 2011).
60. Kimmel, A. J., Rumors and Rumor Control (Mahwah, NJ: Erlbaum, 2004), http://books.google.com/books?id=a0FZz3Jq8lIC&pg=PA64&lpg=PA64&dq=rumors+about+Coke&source=web &ots=wtBktafiKZ&sig=HbsDm2Byd0ZPkZH2YUWITwWTDac&hl=en&sa=X&oi=book_ result&resnum=6&ct=result (accessed October 11, 2011).
61. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 351–53.
62. McConnell, C. R., “Controlling the Grapevine,” Small Business Toolbox, June 18, 2008, http://www.nfib.com/object/IO_37650?_templateId=315 (accessed September 6, 2008).
63. Watson, S. A., “Sharing Info and Defusing Rumors Helps Keep Staff Motivated During Layoffs,” ZDNet, July 29, 2003, http://www.zdnetasia.com/sharing-info-and-defusing-rumors-helps-keep-staff-motivated-during-layoffs-39140816.htm (accessed October 11, 2011).
64. Thill, J. V., and Courtland L. Bovée, Excellence in Business Communication, 8th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 4–6.
65. Brownell, J., Listening, 2nd ed. (Boston: Allyn & Bacon, 2002), 9–10.
66. Artotem – IHOP Cell Phone Meal Family – CC BY 2.0.
67. Kramer, M. G., Business Communication in Context: Principles and Practice (Upper Saddle River, NJ: Prentice Hall, 2001), 87.
68. Greenberg, J., and Robert A. Baron, Behavior in Organizations, 9th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 351–53.
69. Tannen, D., Talking 9 to 5: Women and Men at Work (New York: Avon, 1995).
70. Whetten, D. A., and Kim S. Cameron, Developing Management Skills, 7th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 243.
71. George, J. M., and Gareth R. Jones, Understanding and Managing Organizational Behavior, 5th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 544.
72. Tsui, A. S., and Barbara A. Gutek, Demographic Differences in Organizations (Lanham, MD: Lexington Books, 1999), 91–95, http://books.google.com/books?hl=en&id=Rr8jYPKF0hoC&dq=Tsui%2BGutek&printsec=frontcover &source=web&ots=svMB027a6s&sig=pQForzFKUkbWr1HbNBBLE42EoL0&sa= X&oi=book_result&resnum=1&ct=result (accessed September 9, 2008).
73. Russell, R. S., and Bernard W. Taylor, Operations Management, 5th ed. (Hoboken, NJ: Wiley, 2005), 85.
74. College Board, “Writing: A Ticket to Work…or a Ticket Out: A Survey of Business Leaders,” Report of the National Commission on Writing, September 2004, http://www.writingcommission.org/prod_downloads/writingcom/writing-ticket-to-work.pdf (accessed October 11, 2011).
75. Jerz, D. G., and Jessica Bauer, “Writing Effective E-Mail: Top 10 Email Tips,” Jerz‘s Literacy Weblog, March 8. 2011, http://jerz.setonhill.edu/writing/e-text/email/ (accessed October 19, 2011).
76. Barada, P. W., “Confront Your Fears and Communicate,” http://career-advice.monster.com/in-the-office/workplace-issues/confront-your-fears-and-communicate/article.aspx (accessed October 11, 2011).
77. Carnegie, D., “Presentation Tips from Dale Carnegie Training,” Dale Carnegie, http://www.erinhoops.ca/LobbyingHandbook/Presentation_Tips.htm (accessed October 11, 2011).
78. NASA Goddard Space Flight Center – Earth Day Presentation – CC BY 2.0.
79. Iasted, “Making PowerPoint Slides—Avoiding the Pitfalls of Bad Slides,” http://www.iasted.org/conferences/formatting/Presentations-Tips.ppt (accessed October 11, 2011). | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.04%3A_Chapter_7-_Teamwork_and_Communications.txt |
Learning Objectives
1. Define operations management, and discuss the role of the operations manager in a manufacturing company.
2. Describe the decisions made in planning the production process in a manufacturing company.
Like PowerSki, every organization—whether it produces goods or provides services—sees Job 1 as furnishing customers with quality products. Thus, to compete with other organizations, a company must convert resources (materials, labor, money, information) into goods or services as efficiently as possible. The upper-level manager who directs this transformation process is called an operations manager. The job of operations management (OM), then, consists of all the activities involved in transforming a product idea into a finished product, as well as those involved in planning and controlling the systems that produce goods and services. In other words, operations managers manage the process that transforms inputs into outputs. Figure 8.1 “The Transformation Process” illustrates this traditional function of operations management.
In the rest of this chapter, we’ll discuss the major activities of operations managers. We’ll start by describing the role that operations managers play in the various processes designed to produce goods and offer services. Next, we’ll look at the production of goods in manufacturing firms; then, we’ll describe operations management activities in companies that provide services. We’ll wrap up the chapter by explaining the role of operations management in such processes as quality control and outsourcing.
Operations Management in Manufacturing
Like PowerSki, all manufacturers set out to perform the same basic function: to transform resources into finished goods. To perform this function in today’s business environment, manufacturers must continually strive to improve operational efficiency. They must fine-tune their production processes to focus on quality, to hold down the costs of materials and labor, and to eliminate all costs that add no value to the finished product. Making the decisions involved in the effort to attain these goals is the job of the operations manager. That person’s responsibilities can be grouped as follows:
• Production planning. During production planning, managers determine how goods will be produced, where production will take place, and how manufacturing facilities will be laid out.
• Production control. Once the production process is under way, managers must continually schedule and monitor the activities that make up that process. They must solicit and respond to feedback and make adjustments where needed. At this stage, they also oversee the purchasing of raw materials and the handling of inventories.
• Quality control. Finally, the operations manager is directly involved in efforts to ensure that goods are produced according to specifications and that quality standards are maintained.
Let’s take a closer look at each of these responsibilities.
Planning the Production Process
The decisions made in the planning stage have long-range implications and are crucial to a firm’s success. Before making decisions about the operations process, managers must consider the goals set by marketing managers. Does the company intend to be a low-cost producer and to compete on the basis of price? Or does it plan to focus on quality and go after the high end of the market? Perhaps it wants to build a reputation for reliability. What if it intends to offer a wide range of products? To make things even more complicated, all these decisions involve trade-offs. Upholding a reputation for reliability isn’t necessarily compatible with offering a wide range of products. Low cost doesn’t normally go hand in hand with high quality.
With these factors in mind, let’s look at the specific types of decisions that have to be made in the production planning process. We’ve divided these decisions into those dealing with production methods, site selection, facility layout, and components and materials management.
Production-Method Decisions
The first step in production planning is deciding which type of production process is best for making the goods that your company intends to manufacture. In reaching this decision, you should answer such questions as the following:
• How much input do I receive from a particular customer before producing my goods?
• Am I making a one-of-a-kind good based solely on customer specifications, or am I producing high-volume standardized goods to be sold later?
• Do I offer customers the option of “customizing” an otherwise standardized good to meet their specific needs?
One way to appreciate the nature of this decision is by comparing three basic types of processes or methods: make-to-order, mass production, and mass customization. The task of the operations manager is to work with other managers, particularly marketers, to select the process that best serves the needs of the company’s customers.
Make-to-Order
At one time, most consumer goods, such as furniture and clothing, were made by individuals practicing various crafts. By their very nature, products were customized to meet the needs of the buyers who ordered them. This process, which is called a make-to-order strategy, is still commonly used by such businesses as print or sign shops that produce low-volume, high-variety goods according to customer specifications.
Mass Production
Automakers produce a high volume of cars in anticipation of future demand.
By the early twentieth century, however, a new concept of producing goods had been introduced: mass production (or make-to-stock strategy) is the practice of producing high volumes of identical goods at a cost low enough to price them for large numbers of customers. Goods are made in anticipation of future demand (based on forecasts) and kept in inventory for later sale. This approach is particularly appropriate for standardized goods ranging from processed foods to electronic appliances.
Mass Customization
But there’s a disadvantage to mass production: customers, as one contemporary advertising slogan puts it, can’t “have it their way.” They have to accept standardized products as they come off assembly lines. Increasingly, however, customers are looking for products that are designed to accommodate individual tastes or needs but can still be bought at reasonable prices. To meet the demands of these consumers, many companies have turned to an approach called mass customization, which (as the term suggests) combines the advantages of customized products with those of mass production.
This approach requires that a company interact with the customer to find out exactly what the customer wants and then manufacture the good, using efficient production methods to hold down costs. One efficient method is to mass-produce a product up to a certain cut-off point and then to customize it to satisfy different customers.
The list of companies devoting at least a portion of their operations to mass customization is growing steadily. One of the best-known mass customizer is Nike, which has achieved success by allowing customers to configure their own athletic shoes, apparel, and equipment through Nike’s iD program. The Web has a lot to do with the growth of mass customization. Levi’s, for instance, lets a woman find a pair of perfect fitting jeans by going through an online fitting process that first identifies her “curve” type: slight (straight figure), demi (evenly proportioned), bold (curvy figure, which experiences waist gapping in the back), and supreme (curviest shape, which needs a higher rise in the back). Oakley offers customized sunglasses, goggles, watches, and backpacks, while Mars, Inc. can make M&M’s in any color the customer wants (say, school colors) as well as add text and pictures to the candy.[1]
Naturally, mass customization doesn’t work for all types of goods. Most people don’t care about customized detergents or paper products (although a customized Kleenex tissue box with your picture on it and a statement that says, “go ahead…cry over me!” might come in handy after a relationship breakup with your significant other).[2] And while many of us like the idea of customized clothes, footwear, or sunglasses from Levi’s, Nike, or Oakley, we often aren’t willing to pay the higher prices they command.
Facilities Decisions
After selecting the best production process, operations managers must then decide where the goods will be manufactured, how large the manufacturing facilities will be, and how those facilities will be laid out.
Site Selection
In choosing a location, managers must consider several factors:
• To minimize shipping costs, both for raw materials coming into the plant and for finished goods going out, managers often want to locate plants close to suppliers, customers, or both.
• They generally want to locate in areas with ample numbers of skilled workers.
• They naturally prefer locations where they and their families will enjoy living.
• They want locations where costs for resources and other expenses—land, labor, construction, utilities, and taxes—are low.
• They look for locations with a favorable business climate—one in which, for example, local governments might offer financial incentives (such as tax breaks) to entice them to do business in their locales.
Managers rarely find locations that meet all these criteria. As a rule, they identify the most important criteria and aim at satisfying them. In deciding to locate in San Clemente, California, for instance, PowerSki was able to satisfy three important criteria: (1) proximity to the firm’s suppliers, (2) availability of skilled engineers and technicians, and (3) favorable living conditions. These factors were more important than operating in a low-cost region or getting financial incentives from local government. Because PowerSki distributes its products throughout the world, proximity to customers was also unimportant.
Capacity Planning
Now that you know where you’re going to locate, you have to decide on the quantity of products that you’ll produce. You begin by forecasting demand for your product. Forecasting isn’t easy, to estimate the number of units that you’re likely to sell over a given period, you have to understand the industry that you’re in and estimate your likely share of the market by reviewing industry data and conducting other forms of research.
Once you’ve forecasted the demand for your product, you can calculate the capacity requirements of your production facility—the maximum number of goods that it can produce over a given time under normal working conditions. In turn, having calculated your capacity requirements, you’re ready to determine how much investment in plant and equipment you’ll have to make, as well as the number of labor hours required for the plant to produce at capacity.
Like forecasting, capacity planning is difficult. Unfortunately, failing to balance capacity and projected demand can be seriously detrimental to your bottom line. If you set capacity too low (and so produce less than you should), you won’t be able to meet demand, and you’ll lose sales and customers. If you set capacity too high (and turn out more units than you should), you’ll waste resources and inflate operating costs.
Key Takeaways
• The job of operations management is to oversee the process of transforming resources into goods and services.
• The role of operations managers in the manufacturing sector includes production planning, production control, and quality control.
• During production planning, managers determine how goods will be produced (production process), where production will take place (site selection), and how manufacturing facilities will be laid out (layout planning).
• In selecting the appropriate production process, managers compare three basic methods: make-to-order strategy (goods are made to customer specifications), mass production or make-to-stock strategy (high volumes of goods are made and held in inventory for later sale), and mass customization (high volumes of customized goods are made).
• In choosing the site for a company’s manufacturing operations, managers look for locations that minimize shipping costs, have an ample supply of skilled workers, provide a favorable community for workers and their families, offer resources at low cost, and have a favorable business climate.
• Managers estimate the quantity of products to be produced by forecasting demand for their product and then calculating the capacity requirements of the production facility—the maximum number of goods that it can produce over a given period under normal working conditions.
Exercises
1. (AACSB) Analysis
2. (AACSB) Analysis
Facility Layouts
Learning Objective
1. Describe four major types of facility layouts: process, product, cellular, and fixed position.
The next step in production planning is deciding on plant layout—how equipment, machinery, and people will be arranged to make the production process as efficient as possible. In this section, we’ll examine four common types of facility layouts: process, product, cellular, and fixed position.
The process layout groups together workers or departments that perform similar tasks. Goods in process (goods not yet finished) move from one workstation to another. At each position, workers use specialized equipment to perform a particular step in the production process. To better understand how this layout works, we’ll look at the production process at the Vermont Teddy Bear Company. Let’s say that you just placed an order for a personalized teddy bear—a “hiker bear” with khaki shorts, a white T-shirt with your name embroidered on it, faux-leather hiking boots, and a nylon backpack with sleeping bag. Your bear begins at the fur-cutting workstation, where its honey-brown “fur” coat is cut. It then moves to the stuffing and sewing workstation to get its insides and have its sides stitched together. Next, it moves to the dressing station, where it’s outfitted with all the cool clothes and gear that you ordered. Finally, it winds up in the shipping station and starts its journey to your house. For a more colorful “Online Mini-Tour” of this process, log on to the Vermont Teddy Bear Web site at http://www.vermontteddybear.com/Static/Tour-Welcomestation.aspx (or see Figure 8.3 “Process Layout at Vermont Teddy Bear Company”).
Stuffing and sewing -> Dressing -> Shipping->
In a product layout, high-volume goods are produced efficiently by people, equipment, or departments arranged in an assembly line—that is, a series of workstations at which already-made parts are assembled. Just Born, a candy maker located in Bethlehem, Pennsylvania, makes a product called Marshmallow Peeps on an assembly line. First, the ingredients are combined and whipped in huge kettles. Then, sugar is added for color. At the next workstation, the mixture—colored warm marshmallow—is poured into baby-chick–shaped molds carried on conveyor belts. The conveyor-belt parade of candy pieces then moves forward to stations where workers add eyes or other details. When the finished candy reaches the packaging area, it’s wrapped for shipment to stores around the world. To take an online tour of the Marshmallow Peeps production process, log on to the Just Born Web site at http://www.justborn.com/get-to-know-us/our-factory (or see Figure 8.4 “Product Layout at Just Born, Inc.”).
Figure 8.4 Product Layout at Just Born, Inc.
Both product and process layouts arrange work by function. At the Vermont Teddy Bear Company, for example, the cutting function is performed in one place, the stuffing-and-sewing function in another place, and the dressing function in a third place. If you’re a cutter, you cut all day; if you’re a sewer, you sew all day: that’s your function. The same is true for the production of Marshmallow Peeps at Just Born: if your function is to decorate peeps, you stand on an assembly line and decorate all day; if your function is packing, you pack all day.
Arranging work by function, however, isn’t always efficient. Production lines can back up, inventories can build up, workers can get bored with repetitive jobs, and time can be wasted in transporting goods from one workstation to another. To counter some of these problems, many manufacturers have adopted a cellular layout, in which small teams of workers handle all aspects of building a component, a “family” of components, or even a finished product. Each team works in a small area, or cell, equipped with everything that it needs to function as a self-contained unit. Machines are sometimes configured in a U-shape, with people working inside the U. Because team members often share duties, they’re trained to perform several different jobs. Teams monitor both the quantity and the quality of their own output. This arrangement often results in faster completion time, lower inventory levels, improved quality, and better employee morale. Cellular manufacturing is used by large manufacturers, such as Boeing, Raytheon, and Pratt & Whitney,[3] as well as by small companies, such as Little Enterprise, which makes components for robots.[4][5]Figure 8.5 “Cellular Layout” illustrates a typical cellular layout.
Figure 8.5 Cellular Layout
It’s easy to move teddy bears and marshmallow candies around the factory while you’re making them, but what about airplanes or ships? In producing large items, manufacturers use fixed-position layout in which the product stays in one place and the workers (and equipment) go to the product. This is the arrangement used by General Housing Corporation in constructing modular homes. Each house is constructed at the company’s factory in Bay City, Michigan, according to the customer’s design. Because carpenters, electricians, plumbers, and others work on each building inside the climate-controlled factory, the process can’t be hindered by weather. Once it’s done, the house is transported in modules to the owner’s building site and set up in one day. For a closer view of General Housing Corporation’s production process, go to the General Housing Web site at http://www.genhouse.com.
Key Takeaways
• Managers have several production layout choices, including process, product, cellular, and fixed-position.
• The process layout groups together workers or departments that perform similar tasks. At each position, workers use specialized equipment to perform a particular step in the production process.
• In a product layout, high-volume goods are produced in assembly-line fashion—that is, a series of workstations at which already-made parts are assembled.
• In a cellular layout, small teams of workers handle all aspects of building a component, a “family of components,” or even a finished product.
• A fixed-position layout is used to make large items (such as ships or buildings) that stay in one place while workers and equipment go to the product.
Exercise
(AACSB) Analysis
As purchasing manager for a company that flies corporate executives around the world, you’re responsible for buying everything from airplanes to onboard snacks. You plan to visit all the plants that make the things you buy: airplanes, passenger seats, TV/DVDs that go in the back of the passenger seats, and the specially designed uniforms (with embroidered company logos) worn by the flight attendants. What type of layout should you expect to find at each facility—process, product, or fixed-position? What will each layout look like? Why is it appropriate for the company’s production process? Could any of these plants switch to a cellular layout? What would this type of layout look like? What would be its advantages?
Managing the Production Process in a Manufacturing Company
Learning Objective
1. Identify the activities undertaken by the operations manager in overseeing the production process in a manufacturing company.
Once the production process is in place, the attention of the operations manager shifts to the daily activities of materials management, which encompass the following activities: purchasing, inventory control, and work scheduling.
Purchasing and Supplier Selection
The process of acquiring the materials and services to be used in production is called purchasing (or procurement). For many products, the costs of materials make up about 50 percent of total manufacturing costs. Not surprisingly, then, materials acquisition gets a good deal of the operations manager’s time and attention.
As a rule, there’s no shortage of vendors willing to supply parts and other materials, but the trick is finding the best suppliers. In selecting a supplier, operations managers must consider such questions as the following:
• Can the vendor supply the needed quantity of materials at a reasonable price?
• Is the quality good?
• Is the vendor reliable (will materials be delivered on time)?
• Does the vendor have a favorable reputation?
• Is the company easy to work with?
Getting the answers to these questions and making the right choices—a process known as supplier selection—is a key responsibility of operations management.
E-Purchasing
Technology is changing the way businesses buy things. Through e-purchasing (or e-procurement), companies use the Internet to interact with suppliers. The process is similar to the one you’d use to find a consumer good—say, a forty-two-inch LCD high-definition TV—over the Internet. You might start by browsing the Web sites of TV manufacturers, such as Sony or Samsung, or electronics retailers, such as Best Buy. To gather comparative prices, you might go to a comparison-shopping Web site, such as Amazon.com, the world’s largest online retailer. You might even consider placing a bid on eBay, an online marketplace where sellers and buyers come together to do business through auctions. Once you’ve decided where to buy your TV, you’d complete your transaction online, even paying for it electronically.
If you were a purchasing manager using the Internet to buy parts and supplies, you’d follow basically the same process. You’d identify potential suppliers by going directly to private Web sites maintained by individual suppliers or to public Web sites that collect information on numerous suppliers. You could do your shopping through online catalogs, or you might participate in an online marketplace by indicating the type and quantity of materials you need and letting suppliers bid on prices. (Some of these e-marketplaces are quite large. Covisint, for example, which was started by automakers to coordinate online transactions in the auto industry, is used by more than two hundred and fifty thousand suppliers in the auto industry, as well as suppliers in the health care field.)[6] Finally, just as you paid for your TV electronically, you could use a system called electronic data interchange (EDI) to process your transactions and transmit all your purchasing documents.
The Internet provides an additional benefit to purchasing managers by helping them communicate with suppliers and potential suppliers. They can use the Internet to give suppliers specifications for parts and supplies, encourage them to bid on future materials needs, alert them to changes in requirements, and give them instructions on doing business with their employers. Using the Internet for business purchasing cuts the costs of purchased products and saves administrative costs related to transactions. And it’s faster for procurement and fosters better communications.
Inventory Control
If a manufacturer runs out of the materials it needs for production, then production stops. In the past, many companies guarded against this possibility by keeping large inventories of materials on hand. It seemed like the thing to do at the time, but it often introduced a new problem—wasting money. Companies were paying for parts and other materials that they wouldn’t use for weeks or even months, and in the meantime, they were running up substantial storage and insurance costs.
Most manufacturers have since learned that to remain competitive, they need to manage inventories more efficiently. This task requires that they strike a balance between two threats to productivity: losing production time because they’ve run out of materials, and wasting money because they’re carrying too much inventory. The process of striking this balance is called inventory control, and companies now regularly rely on a variety of inventory-control methods.
Just-in-Time Production
One method is called just-in-time (JIT) production: the manufacturer arranges for materials to arrive at production facilities just in time to enter the manufacturing process. Parts and materials don’t sit unused for long periods, and the costs of “holding” inventory are significantly cut. JIT, however, requires considerable communication and cooperation between the manufacturer and the supplier. The manufacturer has to know what it needs, and when. The supplier has to commit to supplying the right materials, of the right quality, at exactly the right time.
Material Requirements Planning
Another method, called material requirements planning (MRP), relies on a computerized program both to calculate the quantity of materials needed for production and to determine when they should be ordered or made. Let’s say, for example, that you and several classmates are planning a fund-raising dinner for the local animal shelter. First, you estimate how many people will attend—say, fifty. Next, you plan the menu—lasagna, garlic bread, salad, and cookies. Then, you determine what ingredients you’ll need to make the food. Next, you have to decide when you’ll need your ingredients. You don’t want to make everything on the afternoon of the dinner; some things—like the lasagna and cookies—can be made ahead of time. Nor do you want to buy all your ingredients at the same time; in particular, the salad ingredients would go bad if purchased too far in advance. Once you’ve made all these calculations and decisions, you work out a schedule for the production of your dinner that indicates the order and timing of every activity involved. With your schedule in hand, you can determine when to buy each ingredient. Finally, you do your shopping.
Figure 8.6 Lasagna
Making lasagna requires decision making and calculations to ensure a yummy final product. [7]
Though the production process at most manufacturing companies is a lot more complex than planning a dinner (even for fifty), an MRP system is designed to handle similar problems. The program generates a production schedule based on estimated output (your food-preparation timetable for fifty guests), prepares a list of needed materials (your shopping list), and orders the materials (goes shopping).
The basic MRP focuses on material planning, but there’s a more sophisticated system—called manufacturing resource planning (MRP II)—that goes beyond material planning to help monitor resources in all areas of the company. Such a program can, for instance, coordinate the production schedule with HR managers’ forecasts for needed labor.
Work Scheduling
As we’ve seen, manufacturers make profits by transforming inputs (materials and other resources) into outputs (finished goods). We know, too, that production activities, like all business activities, have to be controlled: they have to be monitored to ensure that actual performance satisfies planned performance. In production, the control process starts when operations managers decide not only which goods and how many will be produced, but when. This detailed information goes into a master production schedule (MPS). To draw up an MPS, managers need to know where materials are located and headed at every step in the production process. For this purpose, they determine the routing of all materials—that is, the work flow of each item based on the sequence of operations in which it will be used.
Key Takeaways
• Once the production process is under way, the attention of the operations manager shifts to the daily activities of materials management, which encompasses materials purchasing, inventory control, and work scheduling.
• Because material costs often make up about 50 percent of total manufacturing costs, vendor selection and material acquisition gets a good deal of the operations manager’s time and attention.
• In recent years, the purchasing function has been simplified through technology advances, including e-purchasing and electronic data interchange (EDI), which process transactions and transmit purchasing documents.
• Commonly used inventory control methods include just-in-time (JIT) production, by which materials arrive just in time to enter the manufacturing process, and material requirements planning (MRP), which uses computer programming to determine material needs.
• To schedule jobs, managers create a master production schedule (MPS).
Exercise
What is e-purchasing (or e-procurement)? How does it work? What advantages does it give a purchasing manager? How does it benefit a company? How does it change the relationship between purchasing managers and vendors?
Graphical Tools: PERT and Gantt Charts
Learning Objective
1. Explain how to create and use both PERT and Gantt charts.
Because they also need to control the timing of all operations, managers set up schedules: They select jobs to be performed during the production process, assign tasks to work groups, set timetables for the completion of tasks, and make sure that resources will be available when and where they’re needed. There are a number of scheduling techniques. We’ll focus on two of the most common—Gantt and PERT charts.
Gantt Charts
A Gantt chart, named after the designer, Henry Gantt, is an easy-to-use graphical tool that helps operations managers determine the status of projects. Let’s say that you’re in charge of making the “hiking bear” that we ordered earlier from the Vermont Teddy Bear Company. Figure 8.7 “Gantt Chart for Vermont Teddy Bear” is a Gantt chart for the production of one hundred of these bears. As you can see, it shows that several activities must be completed before the bears are dressed: the fur has to be cut, stuffed, and sewn; and the clothes and accessories must be made. Our Gantt chart tells us that by day six, all accessories and clothing have been made. The stuffing and sewing, however (which must be finished before the bears are dressed), isn’t scheduled for completion until the end of day eight. As operations manager, you’ll have to pay close attention to the progress of the stuffing and sewing operations to ensure that finished products are ready for shipment by their scheduled date.
PERT Charts
Gantt charts are useful when the production process is fairly simple and the activities aren’t interrelated. For more complex schedules, operations managers may use PERT charts. PERT (which stands for Program Evaluation and Review Technique) is designed to diagram the activities required to produce a good, specify the time required to perform each activity in the process, and organize activities in the most efficient sequence. It also identifies a critical path: the sequence of activities that will entail the greatest amount of time. Figure 8.8 “PERT Chart for Vermont Teddy Bear” is a PERT diagram showing the same process for producing one “hiker” bear at Vermont Teddy Bear.
Figure 8.8 PERT Chart for Vermont Teddy Bear
Our PERT chart shows how the activities involved in making a single bear are related. It indicates that the production process begins at the cutting station. Next, the fur that’s been cut for this particular bear moves first to the stuffing and sewing stations and then to the dressing station. At the same time that its fur is moving through this sequence of steps, the bear’s clothes are being cut and sewn and its T-shirt is being embroidered. Its backpack and tent accessories are also being made at the same time. Note that fur, clothes, and accessories all meet at the dressing station, where the bear is dressed and outfitted with its backpack. Finally, the finished bear is packaged and shipped to the customer’s house.
What was the critical path in this process? The path that took the longest amount of time was the sequence that included cutting, stuffing, dressing, packaging, and shipping—a sequence of steps taking sixty-five minutes. If you wanted to produce a bear more quickly, you’d have to save time on this path. Even if you saved the time on any of the other paths—say, the sequence of steps involved in cutting, sewing, and embroidering the bear’s clothes—you still wouldn’t finish the entire job any sooner: the finished clothes would just have to wait for the fur to be stuffed and sewn and moved to the dressing station. In other words, we can gain efficiency only by improving our performance on one or more of the activities along the critical path.
Key Takeaways
• Gantt and PERT charts are two of the most common graphical tools used by operations managers to diagram the activities involved in producing goods.
• A Gantt chart is an easy-to-use graphical tool that helps operations managers determine the status of projects.
• PERT charts are used to diagram the activities required to produce a good, specify the time required to perform each activity in the process, and organize activities in the most efficient sequence.
• A PERT chart identifies a critical path—the sequence of activities that will entail the greatest amount of time.
Exercise
(AACSB) Analysis
Earning a college degree requires not only a lot of hard work but also, as you know, a lot of planning. You must, for example, complete a specified number of credits and take many required courses, particularly in your major. Deciding which courses to take and when to take them can be complicated when some of them have prerequisites. A PERT chart—which diagrams the activities required to complete a goal—might help you determine the order in which you should take courses for your major. Pick a major that interests you and find out what courses you’d need to complete it. Then prepare a PERT chart showing all the courses you’d plan to take each semester to complete your major. (For example, if you select the accounting major, include only accounting courses; don’t include your other business courses or your elective courses.) Identify the critical path laid out in your chart. What happens if you fail to take one of your critical-path courses on time?
The Technology of Goods Production
Learning Objective
1. Explain how manufacturing companies use technology to produce and deliver goods in an efficient, cost-effective manner.
PowerSki founder and CEO Bob Montgomery spent sixteen years designing the Jetboard and bringing it to production. At one point, in his efforts to get the design just right, he’d constructed thirty different prototypes. Needless to say, this process took a very long time, but even so, Montgomery thought that he could handle the designing of the engine without the aid of a computer. Before long, however, he realized that it was impossible to keep track of all the changes.
Computer-Aided Design
That’s when Montgomery turned to computer technology for help and began using a computer-aided design (CAD) software package to design not only the engine but also the board itself and many of its components. The CAD program enabled Montgomery and his team of engineers to test the product digitally and work out design problems before moving to the prototype stage.
The sophisticated CAD software allowed Montgomery and his team to put their design paper in a drawer and to start building both the board and the engine on a computer screen. By rotating the image on the screen, they could even view the design from every angle. Having used their CAD program to make more than four hundred design changes, they were ready to test the Jetboard in the water. During the tests, onboard sensors transmitted data to portable computers, allowing the team to make adjustments from the shore while the prototype was still in the water. Nowadays, PowerSki uses collaboration software to transmit design changes to the suppliers of the 340 components that make up the Jetboard.
Computer-Aided Manufacturing
For many companies, the next step is to link CAD to the manufacturing process. A computer-aided manufacturing (CAM) software system determines the steps needed to produce the component and instructs the machines that do the work. Because CAD and CAM programs can “talk” with each other, companies can build components that satisfy exactly the requirements set by the computer-generated model. CAD/CAM systems permit companies to design and manufacture goods faster, more efficiently, and at a lower cost, and they’re also effective in helping firms monitor and improve quality. CAD/CAM technology is used in many industries, including the auto industry, electronics, and clothing.
Computer-Integrated Manufacturing
By automating and integrating all aspects of a company’s operations, computer-integrated manufacturing (CIM) systems have taken the integration of computer-aided design and manufacturing to a higher level—and are in fact revolutionizing the production process. CIM systems expand the capabilities of CAD/CAM. In addition to design and production applications, they handle such functions as order entry, inventory control, warehousing, and shipping. In the manufacturing plant, the CIM system controls the functions of industrial robots —computer-controlled machines used to perform repetitive tasks that are also hard or dangerous for human workers to perform.
Flexible Manufacturing Systems
Finally, a CIM system is a common element in flexible manufacturing systems (FMS), in which computer-controlled equipment can easily be adapted to produce a variety of goods. An FMS has immense advantages over traditional production lines in which machines are set up to produce only one type of good. When the firm needs to switch a production line to manufacture a new product, substantial time and money are often spent in modifying equipment. An FMS makes it possible to change equipment setups merely by reprogramming computer-controlled machines. Such flexibility is particularly valuable to companies that produce customized products.
Key Takeaways
• In addition to creating high-quality products, companies must produce and deliver goods and services in an efficient, cost-effective manner.
• Sophisticated software systems, including computer-aided design (CAD), computer-aided manufacturing (CAM), computer-integrated manufacturing (CIM), and flexible manufacturing systems (FMS), are becoming increasingly important in this area.
• Computer-aided design software (CAD) is used to create models representing the design of a product.
• Many companies link CAD systems to the manufacturing process through computer-integrated manufacturing (CIM) systems that not only determine the steps needed to produce components but also instruct machines to do the necessary work.
• A CAD/CAM system can be expanded by means of computer-integrated manufacturing (CIM), which integrates various operations (from design through production) with functional activities ranging from order taking to shipping.
• A CIM system is a common element in a flexible manufacturing system (FMS), in which computer-controlled equipment can easily be adapted to produce a variety of goods.
Exercise
(AACSB) Analysis
The design and production of both goods and services can be facilitated by various high-tech tools, including CAD, CAM, CIM, and FMS. What does CAD software do, and how does it improve a design process? What is CAM, and why is it beneficial to integrate CAD and CAM programs? How do CIM systems expand the capabilities of CAD/CAM? What is an FMS, and what are its advantages over traditional manufacturing systems?
Operations Management for Service Providers
Learning Objectives
1. List the characteristics that distinguish service operations from manufacturing operations.
2. Describe the decisions made in planning the product delivery process in a service company.
3. Identify the activities undertaken to manage operations in a service organization.
As the U.S. economy has changed from a goods producer to a service provider, the predominance of the manufacturing sector has declined substantially over the last sixty years. Today, only about 9 percent of U.S. workers are employed in manufacturing, in contrast to 30 percent in 1950.[8][9] Most of us now hold jobs in the service sector, which accounts for 77 percent of U.S. gross domestic product.[10][11] Wal-Mart is now America’s largest employer, followed by IBM, United Parcel Service (UPS), McDonald’s, and Target. Not until we drop down to the seventh-largest employer—Hewlett Packard—do we find a company with even a manufacturing component.[12]
Figure 8.9 Walmart Sign
Wal-Mart employs more than a million people in the United States. [13]
Though the primary function of both manufacturers and service providers is to satisfy customer needs, there are several important differences between the two types of operations. Let’s focus on three of them:
• Intangibility. Manufacturers produce tangible products—things that can be touched or handled, such as automobiles and appliances. Service companies provide intangible products, such as banking, entertainment, or education.
• Customization. Manufactured goods are generally standardized; one twelve-ounce bottle of Pepsi is the same as any other twelve-ounce bottle of Pepsi. Services, by contrast, are often customized to satisfy the specific needs of a customer. When you go to the barber or the hairdresser, you ask for a haircut that looks good on you because of the shape of your face and the texture of your hair. When you go to the dentist, you ask him or her to fill or pull the tooth that’s bothering you.
• Customer contact. You could spend your entire working life assembling cars in Detroit and never meet a customer who bought a car that you helped to make. But if you were a waitress, you’d interact with customers every day. In fact, their satisfaction with your product would be determined in part by the service that you provided. Unlike manufactured goods, many services are bought and consumed at the same time.
Figure 8.10 Burger King
Here is just one of the over twelve thousand Burger King restaurants across the globe. [14]
Not surprisingly, operational efficiency is just as important in service industries as it is in manufacturing. To get a better idea of the role of operations management in the service sector, we’ll look closely at Burger King (BK), home of the Whopper, and the world’s second-largest restaurant chain.[15] BK has grown substantially since selling the first Whopper (for \$0.37) almost half a century ago. The instant success of the fire-grilled burger encouraged the Miami founders of the company to expand by selling franchises. Today, there are 12,200 BK company- and independently-owned franchised restaurants in seventy-three countries (seven thousand of which are in the United States), and they employ almost forty thousand people.[16] More than eleven million customers visit BK each day.[17]
Operations Planning
When starting or expanding operations, businesses in the service sector must make a number of decisions quite similar to those made by manufacturers:
• What services (and perhaps what goods) should they offer?
• How will they provide these services?
• Where will they locate their business, and what will their facilities look like?
• How will they forecast demand for their services?
Let’s see how service firms like BK answer questions such as these.[18]
Operations Processes
Service organizations succeed by providing services that satisfy customers’ needs. Companies that provide transportation, such as airlines, have to get customers to their destinations as quickly and safely as possible. Companies that deliver packages, such as FedEx, must pick up, sort, and deliver packages in a timely manner. Colleges must provide quality educations. Companies that provide both services and goods, such as Domino’s Pizza, have a dual challenge: they must produce a quality good and deliver it satisfactorily.
Service providers that produce goods can, like manufacturers, adopt either a make-to-order or a make-to-stock approach to manufacturing them. BK, which encourages patrons to customize burgers and other menu items, uses a make-to-order approach. BK can customize products because it builds sandwiches one at a time rather than batch-process them. Meat patties, for example, go from the grill to a steamer for holding until an order comes in. Then the patty is pulled from the steamer and requested condiments are added. Finally, the completed sandwich chutes to a counter worker, who gives it to the customer. In contrast, many of BK’s competitors, including McDonald’s, rely on a make-to-stock approach in which a number of sandwiches are made at the same time with the same condiments. If a customer wants, say, a hamburger without onions, he or she has to wait for a new batch of patties to be grilled. The procedure could take up to five minutes, whereas BK can process a special order in thirty seconds.
Like manufacturers, service providers must continuously look for ways to improve operational efficiency. Throughout its sixty-year history, BK has introduced a number of innovations that have helped make the company (as well as the fast-food industry itself) more efficient. BK, for example, was the first to offer drive-through service (which now accounts for 70 percent of its sales.[19]
It was also a BK vice president, David Sell, who came up with the idea of moving the drink station from behind the counter so that customers could take over the time-consuming task of filling cups with ice and beverages. BK was able to cut back one employee per day at every one of its more than eleven thousand restaurants. Material costs also went down because customers usually fill cups with more ice, which is cheaper than a beverage. Moreover, there were savings on supply costs because most customers don’t bother with lids, and many don’t use straws. On top of everything else, most customers liked the system (for one thing, it allowed them to customize their own drinks by mixing beverages), and as a result, customer satisfaction went up, as well. Overall, the new process was a major success and quickly became the industry standard.
Facilities
When starting or expanding a service business, owners and managers must invest a lot of time in selecting a location, determining its size and layout, and forecasting demand. A poor location or a badly designed facility can cost customers, and inaccurate estimates of demand for products can result in poor service, excessive costs, or both.
Site Selection
People in the real estate industry often say that the three most important factors to consider when you’re buying a home are location, location, location. The same principle applies when you’re trying to locate a service business. To be successful in a service industry, you need to be accessible to your customers. Some service businesses, such as cable-TV providers, package-delivery services, and e-retailers, go to their customers. Many others, however—hotels, restaurants, stores, hospitals, and airports—have to attract customers to their facilities. These businesses must locate where there’s a high volume of available customers. Let’s see how BK decides where to place a restaurant.
“Through the light and to the right.” This is a favorite catchphrase among BK planners who are looking for a promising spot for a new restaurant (at least in the United States). In picking a location, BK planners perform a detailed analysis of demographics and traffic patterns, yet the most important factor is usually traffic count—the number of cars or people that pass by a specific location in the course of a day. In the United States, where we travel almost everywhere by car, BK looks for busy intersections, interstate interchanges with easy off and on ramps, or such “primary destinations” as shopping malls, tourist attractions, downtown business areas, or movie theaters. In Europe, where public transportation is much more common, planners focus on subway, train, bus, and trolley stops.
Once planners find a site with an acceptable traffic count, they apply other criteria. It must, for example, be easy for vehicles to enter and exit the site, which must also provide enough parking to handle projected dine-in business. Local zoning must permit standard signage, especially along interstate highways. Finally, expected business must be high enough to justify the cost of the land and building.
Size and Layout
Because manufacturers do business out of plants rarely visited by customers, they base the size and layout of their facilities solely on production needs. In the service sector, however, most businesses must design their facilities with the customer in mind: they must accommodate the needs of their customers while keeping costs as low as possible. Performing this twofold task isn’t easy. Let’s see how BK has met the challenge.
For its first three decades, almost all BK restaurants were pretty much the same. They all sat on one acre of land (located “through the light and to the right”), had about four thousand square feet of space, and held seating for seventy customers. All kitchens were roughly the same size. As long as land was cheap and sites were readily available, this system worked well enough. By the early 1990s, however, most of the prime sites had been taken, if not by BK itself, then by one of its fast-food competitors or other businesses needing a choice spot, including gas stations and convenience stores. With everyone bidding on the same sites, the cost of a prime acre of land had increased from \$100,000 to over \$1 million in a few short years.
To continue growing, BK needed to change the way it found and developed its locations. Planners decided that they had to find ways to reduce the size of a typical BK restaurant. For one thing, they could reduce the number of seats, because the business at a typical outlet had shifted over time from 90 percent inside dining and 10 percent drive-through to a 50-50 split. BK customers tended to be in a hurry, and more customers preferred the convenience of drive-through “dining.”
David Sell (the same executive who had recommended letting customers fill their own drink cups) proposed to save space by wrapping Whoppers in paper instead of serving them in the cardboard boxes that took up too much space in the back room of every restaurant. So BK switched to a single paper wrapper with the label “Whopper” on one side and “Cheese Whopper” on the other. To show which product was inside, employees just folded the wrapper in the right direction. Ultimately, BK replaced pallets piled high with boxes with a few boxes full of wrappers.
Ideas like these helped BK trim the size of a restaurant from four thousand square feet to as little as one thousand. In turn, smaller facilities enabled the company to enter markets that were once cost prohibitive. Now BK could locate profitably in airports, food courts, strip malls, center-city areas, and even schools. The company even designed 10-foot-by-10-foot kiosks that could be transported to special events, stadiums, and concerts.
Capacity Planning
Estimating capacity needs for a service business isn’t the same thing as estimating those of a manufacturer. A manufacturer can predict overall demand, produce the product, store it in inventory, and ship it to a customer when it’s ordered. Service providers, however, can’t store their products for later use: hairdressers can’t “inventory” haircuts, hospitals can’t “inventory” operations, and amusement parks can’t “inventory” roller-coaster rides. Service firms have to build sufficient capacity to satisfy customers’ needs on an “as-demanded” basis. Like manufacturers, service providers must consider many variables when estimating demand and capacity:
• How many customers will I have?
• When will they want my services (which days of the week, which times of the day)?
• How long will it take to serve each customer?
• How will external factors, such as weather or holidays, affect the demand for my services?
Figure 8.11 Walmart Store
Retailers have to be prepared to accommodate much heavier traffic than normal during the holiday season. [20]
Forecasting demand is easier for companies like BK, which has a long history of planning facilities, than for brand-new service businesses. BK can predict sales for a new restaurant by combining its knowledge of customer-service patterns at existing restaurants with information collected about each new location, including the number of cars or people passing the proposed site and the effect of nearby competition.
Managing Operations
Overseeing a service organization puts special demands on managers, especially those running firms, such as hotels, retail stores, and restaurants, that have a high degree of contact with customers. Service firms provide customers with personal attention and must satisfy their needs in a timely manner. This task is complicated by the fact that demand can vary greatly over the course of any given day. Managers, therefore, must pay particular attention to employee work schedules and (in some cases) inventory management. Let’s see how BK deals with these problems.
Scheduling
In manufacturing, managers focus on scheduling the activities needed to transform raw materials into finished goods. In service organizations, they focus on scheduling workers so that they’re available to handle fluctuating customer demand. Each week, therefore, every BK store manager schedules employees to cover not only the peak periods of breakfast, lunch, and dinner, but also the slower periods in between. If he or she staffs too many people, labor cost per sales dollar will be too high. If there aren’t enough employees, customers have to wait in lines. Some get discouraged, and even leave, and many may never come back.
Scheduling is made easier by information provided by a point-of-sale device built into every BK cash register. The register keeps track of every sandwich, beverage, and side order sold by the hour, every hour of the day, every day of the week. Thus, to determine how many people will be needed for next Thursday’s lunch hour, the manager reviews last Thursday’s data, using sales revenue and a specific BK formula to determine the appropriate staffing level. Each manager can adjust this forecast to account for other factors, such as current marketing promotions or a local sporting event that will increase customer traffic.
Inventory Control
Businesses that provide both goods and services, such as retail stores and auto-repair shops, have the same inventory-control problems as manufacturers: keeping levels too high costs money, while running out of inventory costs sales. Technology, such as the point-of-sale registers used at BK, makes the job easier. BK’s system tracks everything sold during a given time and lets each store manager know how much of everything should be kept in inventory. It also makes it possible to count the number of burgers and buns, bags and racks of fries, and boxes of beverage mixes at the beginning or end of each shift. Because there are fixed numbers of supplies—say, beef patties or bags of fries—in each box, employees simply count boxes and multiply. In just a few minutes, the manager knows whether the inventory is correct (and should be able to see if any theft has occurred on the shift).
Key Takeaways
• Though the primary function of both manufacturers and service providers is to satisfy customer needs, there are several important differences between the two types of operations.
• While manufacturers produce tangible, generally standardized products, service firms provide intangible products that are often customized to satisfy specific needs. Unlike manufactured goods, many services are bought and consumed at the same time.
• Operational efficiency is just as important in service industries as it is in manufacturing.
• Operations managers in the service sector make many decisions that are similar to those made by manufacturers: they decide which services to offer, how to provide these services, where to locate their businesses, what their facilities will look like, and what the demand will be for their services.
• Service providers that produce goods can, like manufacturers, adopt either a make-to-order approach (in which products are made to customer satisfaction) or make-to-stock approach (in which products are made for inventory) to manufacturing them.
• Estimating capacity needs for a service business is more difficult than for a manufacturer. Service providers can’t store their services for later use: services must be delivered on an as-needed basis.
• Overseeing a service organization puts special demands on managers, especially services requiring a high degree of contact with customers.
• Given the importance of personalized service, scheduling workers is more complex in the service industry than in manufacturing. In manufacturing, operations managers focus on scheduling the activities needed to produce goods; in service organizations, they focus on scheduling workers to ensure that enough people are available to handle fluctuating customer demand.
Exercise
(AACSB) Analysis
Starting a new business can be an exciting adventure. Here’s your chance to start a “pretend” business. Select a service business that you’d like to open, and answer these questions. Provide an explanation for each answer:
1. What services (and perhaps goods) will I provide?
2. How will I provide these services?
3. Where will I locate my business?
4. What will the facilities look like (how large will the facilities be and what will the layout look like)?
5. How many customers will I serve each day?
6. When will my customers want my services (which days of the week, which times of the day)?
7. How long will it take to serve each customer?
8. Why will my business succeed? Why will my customers return?
Producing for Quality
Learning Objective
1. Explain how manufacturing and service companies alike use total quality management and outsourcing to provide value to customers.
What do you do if you get it home and your brand-new DVD player doesn’t work? What if you were late for class because it took you twenty minutes to get a burger and order of fries at the drive-through window of a fast-food restaurant? Like most people, you’d probably be more or less disgruntled. As a customer, you’re constantly assured that when products make it to market, they’re of the highest possible quality, and you tend to avoid brands that have failed to live up to your expectations or to producers’ claims. You’re told that workers in such businesses as restaurants are there to serve you, and you probably don’t go back to establishments where you’ve received poor-quality service.
But what is quality? According to the American Society for Quality, quality refers to “the characteristics of a product or service that bear on its ability to satisfy stated or implied needs”.[21] When you buy a DVD player, you expect it to play DVDs. When it doesn’t, you question its quality. When you go to a drive-through window, you expect to be served in a reasonable amount of time. If you’re forced to wait, you conclude that you’re the victim of poor-quality service.
Quality Management
To compete today, companies must deliver quality goods and services that satisfy customers’ needs. This is the objective of quality management. Total quality management (TQM), or quality assurance, includes all the steps that a company takes to ensure that its goods or services are of sufficiently high quality to meet customers’ needs. Generally speaking, a company adheres to TQM principles by focusing on three tasks:
1. Customer satisfaction
2. Employee involvement
3. Continuous improvement
Let’s take a closer look at these three principles.
Customer Satisfaction
Companies that are committed to TQM understand that the purpose of a business is to generate a profit by satisfying customer needs. Thus, they let their customers define quality by identifying and offering those product features that satisfy customer needs. They encourage customers to tell them how to make the right products, both goods and services, that work the right way.
Armed with this knowledge, they take steps to make sure that providing quality is a factor in every facet of their operations—from design, to product planning and control, to sales and service. To get feedback on how well they’re doing, many companies routinely use surveys and other methods to monitor customer satisfaction. By tracking the results of feedback over time, they can see where they need to improve.
Employee Involvement
Successful TQM requires that everyone in the organization, not simply upper-level management, commits to satisfying the customer. When customers wait too long at a drive-through window, it’s the responsibility of a number of employees, not the manager alone. A defective DVD isn’t solely the responsibility of the manufacturer’s quality control department; it’s the responsibility of every employee involved in its design, production, and even shipping. To get everyone involved in the drive for quality assurance, managers must communicate the importance of quality to subordinates and motivate them to focus on customer satisfaction. Employees have to be properly trained not only to do their jobs but also to detect and correct quality problems.
In many companies, employees who perform similar jobs work as teams, sometimes called quality circles, to identify quality, efficiency, and other work-related problems, to propose solutions, and to work with management in implementing their recommendations.
Continuous Improvement
An integral part of TQM is continuous improvement: the commitment to making constant improvements in the design, production, and delivery of goods and services. Improvements can almost always be made to increase efficiency, reduce costs, and improve customer service and satisfaction. Everyone in the organization is constantly on the lookout for ways to do things better.
Statistical Process Control
Companies can use a variety of tools to identify areas for improvement. A common approach in manufacturing is called statistical process control. This technique monitors production quality by testing a sample of output to see whether goods in process are being made according to predetermined specifications.
Assume for a moment that you work for Kellogg’s, the maker of Raisin Bran cereal. You know that it’s the company’s goal to pack two scoops of raisins in every box of cereal. How can you test to determine whether this goal is being met? You could use a statistical process control method called a sampling distribution. On a periodic basis, you would take a box of cereal off the production line and measure the amount of raisins in the box. Then you’d record that amount on a control chart designed to compare actual quantities of raisins with the desired quantity (two scoops). If your chart shows that several samples in a row are low on raisins, you’d shut down the production line and take corrective action.
Benchmarking
Sometimes it also helps to look outside the organization for ideas on how to improve operations and to learn how your company compares with others. Companies routinely use benchmarking to compare their performance on a number of dimensions with the performance of other companies that excel in particular areas. Frequent benchmark targets include L.L. Bean, for its superior performance in filling orders; 3M, for its record of introducing innovative products; Motorola, for its success in maintaining consistent quality standards; and Mary Kay Cosmetics, for its skills in inventory control.[22]
International Quality Standards
As a consumer, wouldn’t you like to know which companies ensure that their products meet quality specifications? Some of us would like to know which companies take steps to protect the environment. Some consumers want to know which companies continuously improve their performance in both of these areas—that is, practice both quality management and environmental management. By the same token, if you were a company doing a good job in these areas, wouldn’t you want potential customers to know? It might be worth your while to find out whether your suppliers were also being conscientious in these areas—and even your suppliers’ suppliers.
ISO 9000 and ISO 14000
Through the International Organization for Standardization (ISO), a nongovernmental agency based in Switzerland, it’s possible to find this kind of information. The resources of this organization will enable you to identify those organizations that have people and processes in place for delivering products that satisfy customers’ quality requirements. You can also find out which organizations work to reduce the negative impact of their activities on the environment. Working with representatives from various countries, the organization has established the ISO 9000 family of international standards for quality management and the <ISO 14000 family of international standards for environmental management.
ISO standards focus on the way a company does its work, not on its output (though there’s certainly a strong correlation between the way in which a business functions and the quality of its products). Compliance with ISO standards is voluntary, and the certification process is time-consuming and complex. Even so, hundreds of thousands of organizations around the world are ISO 9000 and ISO 14000 certified.[23] ISO certification has become an internationally recognized symbol of quality management and is almost essential to be competitive in the global marketplace.
Outsourcing
PowerSki’s Web site states that “PowerSki International has been founded to bring a new watercraft, the PowerSki Jetboard, and the engine technology behind it, to market”.[24] That goal was reached in May 2003, when the firm emerged from a lengthy design period. Having already garnered praise for its innovative product, PowerSki was ready to begin mass-producing Jetboards. At this juncture, the management team made a strategic decision that’s not uncommon in manufacturing today. Rather than producing Jetboards in-house, they opted for outsourcing: having outside vendors manufacture the engines, fiberglass hulls, and associated parts. Assembly of the final product took place in a manufacturing facility owned by All American Power Sports in Moses Lake, Washington. This decision doesn’t mean that the company relinquished control over quality; in fact, every component that goes into the PowerSki Jetboard is manufactured to exact specifications set by PowerSki. One advantage of outsourcing its production function is that the management team can thereby devote its attention to refining its product design and designing future products.
Outsourcing in the Manufacturing Sector
Outsourcing the production of its engines, hulls, and other components enables PowerSki to reduce the cost of producing each Jetboard through manufacturing efficiencies and lower labor costs. All components that go into the Jetboard are made to PowerSki’s specifications and are inspected upon arrival to ensure that they meet the company’s high-quality standards.
Understandably, outsourcing is becoming an increasingly popular option among manufacturers. For one thing, few companies have either the expertise or the inclination to produce everything needed to make a product. Today, more firms, like PowerSki, want to specialize in the processes that they perform best—and outsource the rest. Like PowerSki, they also want to take advantage of outsourcing by linking up with suppliers located in regions with lower labor costs.
Outsourcing in the Service Sector
Outsourcing is by no means limited to the manufacturing sector. Service companies also outsource many of their noncore functions. Your school, for instance, probably outsources such functions as food services, maintenance, bookstore sales, printing, groundskeeping, security, information-technology (IT) support, and even residence operations.
Key Takeaways
• Today, companies that compete in both the manufacturing and service sectors must deliver quality goods and services that satisfy customers’ needs. Many companies achieve this goal by adhering to principles of total quality management (TQM).
• Companies using a TQM approach focus on customer satisfaction, engage all members of the organization in quality efforts, and strive for continuous improvement in the design, production, and delivery of goods and services. They also benchmark other companies to find ways to improve their own performance.
• To identify areas for improvement, companies can use a technique called statistical process control (SPC), which monitors quality by testing to see whether a sample of output is being made to predetermined specifications.
• Another cost-saving approach is outsourcing—having outside vendors manufacture components or even entire products or provide services, such as information-technology support or service center operations.
• Outsourcing is an appealing option for companies without the expertise in producing everything needed to make a product or those that want to take advantage of low labor costs in developing countries.
Exercises
1. (AACSB) Analysis
2. (AACSB) Analysis
Cases and Problems
Learning on the Web (AACSB)
How to Build a BMW
How’d you like to own a Series 3 BMW? How about a convertible priced at \$48,000 for those warm summer days? Or maybe a less expensive coupe for \$39,000? Or, if you need more space for hauling camping equipment, dogs, or kids, maybe you would prefer a wagon at \$37,000? We can’t help you finance a BMW, but we can show you how they’re made. Go to http://www.bmw-plant-munich.com/ to link to the BMW Web site for a virtual tour of the company’s Munich, Germany, plant.
First, click on “Location” and then on “The Plant in Figures.” Before going any further, answer the following questions:
1. How many associates (employees) work in the plant?
2. How many apprentices (trainees) work there? Why does the plant have trainees?
3. How many cars are made in the plant each day? How many engines?
Next, click on “Production” to open a drop-down list that looks like this:
Fascination Production
Press Shop
Body Shop
Paint Shop
Engine Assembly
Assembly
Click on “Fascination Production,” and watch a video that zips you through the production steps needed to make a BMW. Continue your tour by clicking on each progressive step taken to build a quality car: press shop, body shop, paint shop, engine assembly and final assembly. After reading about and watching the brief video describing the work done in a particular area of the plant, pause and answer the following questions (you will answer this set of questions five times—once for each of these areas of the factory: press shop, body shop, paint shop, engine assembly, and final assembly):
1. What production steps occurred in this area of the plant?
2. What technology does BMW use in the production process?
3. Approximately what percentage of the work was done by people?
4. What procedures were followed to ensure the production of high-quality vehicles?
Career Opportunities
Wanted: Problem Solvers and Creative Thinkers
If you had a time machine plus a craving for a great hamburger, you could return to the early 1950s and swing by Dick and Mac McDonald’s burger stand in San Bernardino, California. Take a break from eating and watch the people in the kitchen. You’ll see an early application of operations management in the burger industry. Dick and Mac, in an effort to sell more burgers in less time, redesigned their kitchen to use assembly-line procedures. As the number of happy customers grew, word spread about their speedy system, and their business thrived. Curiously, it wasn’t Dick and Mac who made McDonald’s what it is today, but rather a traveling milkshake-mixer salesman named Ray Kroc. He visited the hamburger stand to learn how they could sell twenty thousand shakes a year. When he saw their operations and the lines of people walking away with bags filled with burgers, fries, and shakes, he knew he had a winner. In cooperation with the McDonald brothers, he started selling franchises around the country, and the rest is history.
So, what does this story have to do with a career in operations management? If you’re a problem solver like Dick and Mac (who discovered a way to make burgers faster and cheaper) or a creative thinker like Ray Kroc (who recognized the value in an assembly-line burger production system), then a career in operations management might be for you. The field is broad and offers a variety of opportunities. To get a flavor of the choices available, go to http://www.wetfeet.com/Careers-and-Industries/Careers/Operations.aspx to link to the WetFeet Web site and review the dozen or so operations management positions listed. Provide a brief description of each position. Indicate how interesting you find each position by rating it using a five-point scale (with 1 being uninteresting and 5 being very interesting). Based on your assessment, pick the position you find most interesting and the one you find least interesting. Explain why you made your selections.
Ethics Angle (AACSB)
In many ways, Eastman Kodak (a multinational manufacturer and distributor of photographic equipment and supplies) is a model corporate citizen. Fortune magazine has ranked it as one of the country’s most admired companies, applauding it in particular for its treatment of minorities and women. Its community-affairs programs and contributions have also received praise, but Eastman Kodak remains weak in one important aspect of corporate responsibility: it has consistently received low scores on environmental practices. For example, the watchdog group Scorecard rated Eastman Kodak’s Rochester, New York, facility as the third-worst emitter of airborne carcinogens in the United States. Other reports have criticized the company for dumping cancer-causing chemicals into the nation’s waters.
Go to http://www.kodak.com/US/en/corp/HSE/homepage.jhtml?pd-path=2879/7196 to link to the Eastman Kodak Web site and read its own assessment of its environmental practices. Then answer the following questions:
• Based on the information provided on its Web site, how favorable do you feel about Eastman Kodak’s environmental practices?
• In what ways is the company responding to criticisms of its environmental practices and improving them?
• Do the statements on the Web site mesh with the criticism that the company has received? If not, what accounts for the differences?
Team-Building Skills (AACSB)
Growing Accustomed to Your Fit
Instead of going to the store to try on several pairs of jeans that may or may not fit, wouldn’t it be easier to go online and order a pair of perfect-fitting jeans? Lands’ End has made this kind of shopping possible through mass-customization techniques and some sophisticated technology.
To gain some firsthand experience at shopping for mass-customized goods, have each member of your team go to Nike’s iD site at http://nikeid.nike.com. Each team member should go through the process of customizing a different Nike product but stop right before placing an order. After everyone has gone through the process, get together and write a report in which the team explains exactly what’s entailed by online mass customization and details the process at Nike. Be sure to say which things impressed you and which didn’t. Explain why Nike developed this means of marketing products and, finally, offer some suggestions on how the process could be improved.
The Global View (AACSB)
What’s the State of Homeland Job Security?
Over the past several decades, more and more U.S. manufacturers began outsourcing production to such low-wage countries as Mexico and China. The number of U.S. manufacturing jobs dwindled, and the United States became more of a service economy. People who were directly affected were understandably unhappy about this turn of events, but most people in this country didn’t feel threatened. At least, not until service jobs also started going to countries that, like India, have large populations of well-educated, English-speaking professionals. Today, more technology-oriented jobs, including those in programming and Internet communications, are being outsourced to countries with lower wage rates. And tech workers aren’t alone: the jobs of accountants, analysts, bankers, medical technicians, paralegals, insurance adjusters, and even customer-service representatives have become candidates for overseas outsourcing.
Many U.S. workers are concerned about job security (though the likelihood of a particular individual’s losing a job to an overseas worker is still fairly low). The issues are more complex than merely deciding where U.S. employers should be mailing paychecks, and politicians, economists, business executives, and the general public differ about the causes and consequences of foreign outsourcing. Some people think it’s a threat to American quality of life, while others actually think that it’s a good thing.
Spend some time researching trends in outsourcing. Formulate some opinions, and then answer the following questions:
1. About what percentage of U.S. jobs have left the country in the last five years? What percentage will probably leave in the next five years?
2. What kinds of jobs are being outsourced, and where are they going? What kinds of jobs can’t be outsourced?
3. How does global outsourcing help U.S. businesses? How does it hinder them?
4. How has the trend in outsourcing manufacturing and service operations to foreign countries helped average Americans? How has it harmed them?
5. Does overseas outsourcing help or hurt the U.S. economy? In what ways?
1. See these websites for examples of customized products: Nike (http://nikeid.nike.com/nikeid/index.jsp), Levi (http://us.levi.com/shop/index.jsp?categoryId=4370093), Oakley (http://www.oakley.com/custom), and Mar’s M&M’s (http://www.mymms.com/utility.aspx?src=) (accessed November 2, 2011).
2. Windisman, A., “Personalized Packaging: Kleenex Offers Customizable Tissue Boxes,” One of a Kind Publishing, Inc., January 3, 2008, http://blogs.oneofakindpublishing.com/index.php?/archives/77-Personalized-Packaging-Kleenex-Offers Customizable-Tissue-Boxes.html (accessed November 1, 2011).
3. Chaneski, W., “Cellular Manufacturing Can Help You,” Modern Machine Shop, August 1, 1998, http://www.mmsonline.com/columns/cellular-manufacturing-can-help-you (accessed November 1, 2011).
4. Modern Machine Shop Magazine, 2001, “Better Production—Manufacturing Cell Boosts Profits and Flexibility,” Modern Machine Shop Magazine, May 2001, http://www.mmsonline.com/articles/manufacturing-cell-boosts-profits-and-flexibility (accessed November 2, 2011)
5. Little Enterprises, Inc., http://www.littleent.com/industries.html (accessed November 2, 2011).
6. Jingzhi, “Covisint.com,” http://www.sftw.umac.mo/~jzguo/pages/covisint.html (accessed November 2, 2011).
7. David K – lasagna – CC BY-SA 2.0.
8. The Global Language Monitor, “Avoiding an American ‘Lost Decade,’” The Global Language Monitor, November 3, 2010, http://www.languagemonitor.com/tag/percentage-of-the-non-farm-payroll-in-manufacturing/ (accessed November 2, 2011).
9. Strauss, W., “Is U.S. Manufacturing Disappearing?,” Federal Reserve Bank of Chicago, August 19, 2010, http://midwest.chicagofedblogs.org/archives/2010/08/bill_strauss_mf.html#footnote2 (accessed November 2, 2011).
10. International Monetary Fund, “International Monetary Fund, World Economic Outlook Database, April 2011: Nominal GDP List of Countries. Data For The Year 2010,” International Monetary Fund, http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx (accessed November 2, 2011).
11. Wikipedia, s.v. “List of Countries by GDP Sector Composition,” http://en.Wikipedia.org/wiki/List_of_countries_by_GDP_sector_composition (accessed November 2, 2011).
12. 24/7 Wall Street, “America’s Ten Largest Employers,” 24/7 Wall Street, April 10, 2011, http://247wallst.com/2011/04/24/americas-ten-largest-employers/#ixzz1ayiE71Sr (accessed November 2, 2011).
13. Mike Mozart – Walmart – CC BY 2.0.
14. Mike Mozart – ”Burger King” “Burger King Size” – CC BY 2.0.
15. Burger King, “Press Room,” Burger King, http://www.bk.com/en/us/company-info/press/index.html (accessed November 2, 2011).
16. SEC, 10K SEC Filings, Burger King Corporation, August 2010, http://services.corporate-ir.net/SEC.Enhanced/SecCapsule.aspx?c=87140&fid=7105569 (accessed November 3, 2011).
17. Burger King, “Press Room,” Burger King, http://www.bk.com/en/us/company-info/press/index.html (accessed November 2, 2011).
18. Information on Burger King was obtained from an interview with David Sell, former vice president of Central, Eastern, and Northern Europe divisions and president of Burger King France and Germany.
19. Krummert, B., “Burger King: Headed For A Fast-Casual Flameout?,” Restaurant Hospitality,http://restaurant-hospitality.com/news/burger-king-headed-flameout-1019/ (accessed November 3, 2011).
20. Laurie – Walmart on Black Friday 2009 – CC BY-NC-ND 2.0.
21. American Society of Quality, “Basic Concepts, Definitions,” American Society of Quality, http://asq.org/glossary/q.html (accessed November 3, 2011).
22. Nuese, C. J., Building the Right Things Right (New York: Quality Resources, 1995), 102.
23. (ISO) International Organization for Standardization, “ISO Survey of Certifications,” 2009 International Organization for Standardization, http://www.iso.org/iso/survey2009.pdf (accessed November 2, 2011).
24. PowerSki, “About PowerSki International,” PowerSki, http://www.powerski.com/aboutpsi.htm (accessed November 3, 2011). | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.05%3A_Chapter_8-_Operations_Management_in_Manufacturing_and_Service_Industries.txt |
Riding the Crest of Innovation
To see the PowerSki Jetboard in action, visit the company’s Web site at http://www.powerski.com. Watch the streaming videos that demonstrate what the Jetboard can do.
Have you ever wanted to go surfing but couldn’t find a body of water with decent waves? You no longer have a problem: the PowerSki Jetboard makes its own waves. This innovative product combines the ease of waterskiing with the excitement of surfing. A high-tech surfboard with a forty-five-horsepower, forty-five-pound watercraft engine, the PowerSki Jetboard has the power of a small motorcycle. Experienced surfers use it to get to the top of rising ocean waves, but if you’re just a weekend water-sports enthusiast, you can get your adrenaline going by skimming across the surface of a local lake at forty miles an hour. All you have to do is submerge the tail of the board, slide across on your belly, and stand up (with the help of a flexible pole). To innocent bystanders, you’ll look like a very fast water-skier without a boat.
Where do product ideas like the PowerSki Jetboard come from? How do people create products that meet customer needs? How are ideas developed and turned into actual products? How do you forecast demand for a product? How do you protect your product ideas? These are some of the questions that we’ll address in this chapter.
What Is a Product?
Learning Objectives
1. Define product.
2. Describe the four major categories of product developments: new-to-the-market, new-to-the-company, improvement of existing product, and extension of product line.
Basically, a product is something that can be marketed to customers because it provides them with a benefit and satisfies a need. It can be a physical good, such as the PowerSki Jetboard, or a service, such as a haircut or a taxi ride. The distinction between goods and services isn’t always clear-cut. Say, for example, that a company hires a professional to provide an in-house executive training program on “netiquette” (e-mail etiquette). Off the top of our heads, most of us would say that the company is buying a service. What if the program is offered online? We’d probably still argue that the product is a service. But what if the company buys training materials that the trainer furnishes on DVD? Is the customer still buying a service? Probably not: we’d have to say that when it buys the DVD, the company is buying a tangible good.
In this case, the product that satisfies the customer’s need has both a tangible component (the training materials on DVD) and an intangible component (the educational activities performed by the seller). Not surprisingly, many products have both tangible and intangible components. If, for example, you buy a Hewlett-Packard computer, you get not only the computer (a tangible good) but certain promises to answer any technical questions that you might have and certain guarantees to fix your computer if it breaks within a specified time period (intangible services).
Types of Product Developments
New product developments can be grouped into four major categories: new-to-the-company, improvement of existing product, extension of product line, and new-to-the-market.
Figure 9.1 Peeps Milk Chocolate
Holiday decorating kits have extended Just Born’s product line beyond Peeps[1]
For examples of the first three types of new product developments, we’ll take a look at Just Born. The company is known for its famous “Marshmallow Peeps,” and consequently its management is very interested in marshmallows. It conducted research that revealed that families use marshmallows in lots of ways, including crafts and decorating. This led Just Born to develop an Easter decorating kit that used Peeps marshmallows. It was such a hit that the company followed by creating decorating kits for Halloween and the Christmas season. Because similar products are made by other companies, the decorating kits are not “new to the market” but are “new to the company.” Now, let’s look at another product development involving Just Born’s also famous Mike & Ike’s. The marketing people at Just Born discovered that teenagers prefer to buy candies that come in pouches (which fit into their pants pockets) rather than in small boxes. In response, the company reduced the piece size, added some new ingredients, and put the Mike & Ike’s in pouches. This “improvement in an existing product” resulted in a 20 percent annual sales jump for Mike & Ike’s. Our last look at Just Born demonstrates an approach used by the company to “extend its existing product line.” Most of us like chocolate and most of us also like marshmallow, so how about putting them together? This is just what Just Born did—the company extended its Peeps product line to include “Peeps in a chocolate egg.” Consumers loved the combination, and its success prompted the company to extend its product line again and launch a chocolate crispy version for Easter.
New-to-the-Market Products
The PowerSki Jetboard is a “new-to-the-market product.” Before it was invented, no comparable product existed. Launching a new-to-the-market product is very risky, and only about 10 percent of products created fall into this category. On a positive note, introducing a new product to the market can be very profitable, because the product often enjoys a temporary monopolistic position.
Entreprenerial Start-Ups
Inventors of new-to-the-market products often form entrepreneurial start-ups to refine their product idea and bring it to market. This was the path taken by Bob Montgomery, inventor of the PowerSki Jetboard. As is typical of entrepreneurial start-ups, the company that Montgomery founded has these characteristics:[2]
• It’s characterized by innovative products and/or practices. Before the PowerSki Jetboard was invented, no comparable product existed.
• Its goals include profitability and growth. Because the patented Jetboard enjoys a temporary monopolistic position, PowerSki potentially could be very profitable.
• It focuses on new opportunities. Bob Montgomery dreamed of creating the first motorized surfboard. This dream began when he and a few of his surfer friends (all around age twelve) missed a wave because it was too far down the beach for them to catch. He imagined that if he was on a motorized surfboard (instead of an ordinary one that you had to paddle), he would have been able to catch that wave. His dream became the mission of his company: “PowerSki International Corp. was founded to deliver the patented PowerSki Jetboard, the world’s only motorized surfboard, and its engine technology to the world market. It’s PowerSki’s goal to bring the experience of surfing to everyone on lakes, rivers, seas, and the ocean. ‘Now everybody has an ocean, and can ride an endless wave’”.[3]
• Its owners are willing to take risks. Anybody who starts any business is taking a risk of some kind. The key to entrepreneurial risk is related to the idea of innovation: as Woody Allen once put it, “If you’re not failing every now and again, it’s a sign you’re not doing anything very innovative”. [4]
How to Take a Calculated Risk
As Montgomery learned, the introduction of an innovative product to the market is more unpredictable, and thus more risky, than the introduction of a market-tested product. Starting up a store to sell an improved version of an existing surfboard entails one level of risk; starting up a business to market the first motorized surfboard entails quite another. Even though the introduction of new-to-the-market products are more risky, some of this risk can be avoided. What if, for example, Montgomery had brought the Jetboard to market only to discover that many of the buyers in his target market—water-sports enthusiasts—couldn’t easily maneuver the Jetboard? We could then say that he took an unnecessarily risky step in bringing his product to market, but we could also say that he simply attempted to market his product without adequate information. Surely a little research would have alerted Montgomery to the probable consequences of his decision to go to market when he did and with his product in its current state of development.
A couple of final words, therefore, about introducing an entirely new product to the market. First, this type of product introduction is about carefully calculated risks, not unnecessary risks. Second, though little is certain in the entrepreneurial world, most decision making can be improved with input from one or both of two sources:
1. Information gathered from research
2. Knowledge gained from personal experience
Again, you can’t be certain about any results, but remember that uncertainty reflects merely the lack of complete knowledge or information; thus, the more knowledge and information that you can bring to bear on a situation, the less uncertain—and the less risky—the decision becomes.[5] In short, always do your homework, and if you’re new to entrepreneurship or to your market, make it a point to work with people who know from experience what they’re talking about.
Key Takeaways
• A product is something that can be marketed to customers because it provides them with a benefit and satisfies a need. Products can be goods or services or a combination of both.
• A “new-to-the-company product” is a good or a service that is new to the company but has been sold by a competitor in the past—for example, Peeps marshmallow Easter decorating kits.
• An “improvement in an existing product” is an enhancement of a product already on the market—for example, a change of ingredients and packaging for Mike & Ike’s.
• An “extension to an existing product line” is a new product developed as a variation of an already existing product—for example, Peeps chocolate eggs.
• A “new-to-the-market product” is a good or a service that has not been available to consumers or manufacturers in the past—for example, the PowerSki Jetboard.
• Four characteristics of the entrepreneurial start-up are:
1. It’s characterized by innovative products and/or practices.
2. Its goals include profitability and growth.
3. It focuses on new opportunities.
4. Its owners are willing to take risks.
• Entrepreneurship is about carefully calculated risks, not unnecessary risks. Most entrepreneurial decision making can be improved with input from one or both of two sources:
1. Information gathered from research
2. Knowledge gained from personal experience
Exercise
(AACSB) Analysis
Identify a good or a service for each of the following product development categories: new-to-the-market, new-to-the-company, improvement of existing product, and extension of product line. To come up with the products, you might visit a grocery store or a mall. Don’t use the Just Born examples presented in the chapter.
Where Do Product Ideas Come From?
Learning Objective
1. Explain where product ideas come from.
For some people, coming up with a great product idea is a gratifying adventure. For most, however, it’s a daunting task. The key to coming up with a product idea is identifying something that customers want—or, perhaps more important, filling an unmet customer need. In coming up with a product idea, ask not “what do I want to sell?” but rather “what does the customer want to buy?”[6] With this piece of advice in mind, let’s get back to the task of coming up with a product idea. Nobel Prize–winning chemist Linus Pauling suggested that “the best way to have a good idea is to have lots of ideas,” and though this notion might seem a little whimsical at first, it actually makes a lot of sense, especially if you’re trying to be innovative in the entrepreneurial sense. Every year, for example, companies launch about thirty thousand new food, beverage, and beauty products, and up to 90 percent fail within a year.[7][8] You might need ten good ideas just to have one that stands a chance.
Purple Cow Ideas
So where do these ideas come from? Product ideas can originate from almost anywhere. How many times have you looked at a product that just hit the market and said, “I could have thought of that”? Just about anybody can come up with a product idea; basically, you just need a little imagination. Success is more likely to result from a truly remarkable product—something that grabs the attention of consumers. Entrepreneur and marketing consultant Seth Godin refers to truly remarkable products as “purple cows”.[9] He came up with the term while driving through the countryside one day. As he drove along, his interest was attracted by the hundreds of cows dotting the countryside. After a while, however, he started to ignore the cows because looking at them had become tedious. For one thing, they were all brown, and it occurred to him that a glimpse of a purple cow would be worth writing home about. People would tend to remember a purple cow; in fact, they might even want one.
Who thinks up “purple cow” ideas? Where do the truly remarkable business ideas come from? As we pointed out in an earlier chapter, entrepreneurs and small business owners are a rich source of new product ideas (according to the Small Business Administration, 55 percent of all new product innovations come from small businesses). Take Dean Kamen, inventor of the Segway Human Transporter, a battery-operated vehicle that responds to the rider’s movements: lean forward and you can go straight ahead at 12.5 miles per hour; to stop, just tilt backward. This revolutionary product is only one of Kamen’s many remarkable business ideas. He invented his first product—a wearable infusion pump for administering chemotherapy and other drugs—while he was still a college undergraduate.[10][11] Jacob Dunnack is also getting an early entrepreneurial start. At age six, Jacob became frustrated one day when he took his baseball bat to his grandmother’s house but forgot to take some baseballs as well. His solution? A hollow baseball bat that holds baseballs. Dunnack’s invention, now called the JD Batball, was quickly developed and sold in stores such as Toys “R” Us.[12][13]
Why do so many entrepreneurs and small businesspeople come up with so many purple cows? For one thing, entrepreneurs are often creative people; moreover, they’re often willing to take risks. This is certainly true of Bob Montgomery, inventor of the PowerSki Jetboard (which undoubtedly qualifies as a purple cow). With more than twenty years’ experience in the water-sports industry and considerable knowledge of the personal-watercraft market, Montgomery finally decided to follow his long-cherished dream of creating an entirely new and conceptually different product—one that would offer users ease of operations, high performance, speed, and quality. His creative efforts have earned him the prestigious Popular Science “Best of What’s New” award.[14]
To remain competitive, medium and large organizations alike must also identify product development opportunities. Many companies actively solicit product ideas from people inside the organization, including marketing, sales, research, and manufacturing personnel, and some even establish internal “entrepreneurial” units. Others seek product ideas from outside the organization by talking to customers and paying attention to what the competition is doing. In addition to looking out for new product ideas, most companies constantly seek out ways to make incremental improvements in existing products by adding features that will broaden their consumer appeal. As you can see from Figure 9.2 “Sales from New Products”, the market leaders in most industries are the firms that are most successful at developing new products.
Figure 9.2 Sales from New Products
A novel approach to generating new-to-the-world product ideas is hiring “creativity” consultants. One of the best is Doug Hall, who’s been called “America’s Number 1 Idea Guru.” At a Cincinnati idea factory called Eureka!Ranch, Hall and other members of his consulting firm specialize in helping corporate executives get their creative juices flowing.[15] Hall’s job is getting people to invent products that make a real difference to consumers, and his strategies are designed to help corporate clients become more innovative—to jump-start their brains. As Hall puts it, “You have to swing to hit home runs”.[16] Eureka!Ranch’s client list includes Disney, Kellogg, Johnson & Johnson, and Procter & Gamble, as well as a number of budding entrepreneurs. Hall boasts that the average home uses eighteen goods or services that the Ranch helped shape, and if he’s right, you yourself have probably benefited from one of the company’s idea-generating sessions.[17]
Key Takeaways
• The majority of product ideas come from entrepreneurs and small business owners, though medium and large organizations also must identify product-development opportunities in order to remain competitive.
• Firms seek product ideas from people inside the organization, including those in marketing, sales, research, and manufacturing, as well as from customers and others outside the organization.
Exercise
(AACSB) Analysis
The “Strange New Products” Web site brags that it displays the “weirdest, funniest, stupidest, and [most] ingenious new products entering the marketplace.” This seems to be an accurate statement. Visit the site (http://www.strangenewproducts.com) and do the following:
1. Pick your favorite new product.
2. Describe the idea.
3. Explain how the product works.
4. Indicate whether you believe the product fills an unmet need. Explain why or why not.
5. Rate the product’s likelihood of success on a scale from 1 (extremely unlikely) to 10 (very likely). Explain your rating.
Identifying Business Opportunities
Learning Objectives
1. Explain how an idea turns into a business opportunity.
2. Describe the four types of utility provided by a product: time, place, ownership, and form.
An idea turns into a business opportunity when it has commercial potential—when you can make money by selling the product. But needless to say, not all ideas generate business opportunities. Consider these products that made the list of the “Top 25 Biggest Product Flops of All Time”:[18]
• Bic underwear. When you think of Bic you think of inexpensive pens and disposable razors and lighters. But disposable underwear? Women didn’t find the idea of buying intimate attire from a pen manufacturer appealing, and the disposability factor was just plain weird.
Figure 9.3 Bic Lighter
There might be many creative ways for Bic to extend its product lines, aside from the disposable underwear idea. Can you think of a product idea that might be more successful for Bic? [19]
• Harley Davidson perfume. Even its loyal fans found the idea of Harley-Davidson perfume peculiar (and they weren’t terribly fond of the Harley-Davidson aftershave, either). Perhaps they were afraid they would end up smelling like a motorcycle.
• Bottled water for pets. OK, so people love their pets and cater to them, but does it really make sense to serve Thirsty Cat! and Thirsty Dog! bottled water to your four-legged friends? Even though the water came in tantalizing flavors such as Crispy Beef and Tangy Fish, it never caught on. Do you wonder why?
• Colgate kitchen entrees. Colgate’s entrance into food products wasn’t well received. Maybe the company believed customers would buy into the idea of eating one of its prepared meals and then brushing their teeth with Colgate toothpaste. For most of us, the name Colgate doesn’t get our taste buds tingling.
Utility
Remember: being in business is not about you—it’s about the customer. Successful businesspeople don’t ask themselves “What do I want to sell?” but rather “What does the customer want to buy?” Customers buy products to fill unmet needs and because they expect to derive some value or utility from them. People don’t buy Alka-Seltzer because they like the taste or even because the price is right: they buy it because it makes their indigestion go away. They don’t shop at Amazon.com because the Web site is entertaining: they shop there because they want their purchases delivered quickly. The realization that this kind of service would meet customer needs made Amazon.com a genuine business opportunity.
Products provide customers with four types of utility or benefit:
1. Time utility. The value to a consumer of having a good or a service available at a convenient time. A concessionaire selling bottled water at a summer concert is making liquid refreshment available when it’s needed.
2. Place utility. The value to a consumer of having a product available in a convenient location. A street vendor selling hotdogs outside an office building is making fast food available where it’s needed.
3. Ownership utility. Value created by transferring a product’s ownership. A real estate agent helping a young couple buy a home is transferring ownership from someone who doesn’t need it to someone who does.
4. Form utility. The value to consumers from changing the composition of a product. A company that makes apparel is turning raw material (fabric) into a form (clothing) that people need. A company that produces liquid detergent, rather than powdered detergent, is adding form utility for some consumers.
How can you decide whether an idea provides utility and has the potential to become a business opportunity? You should start by asking yourself the questions in Figure 9.4 “When Is an Idea a Business Opportunity?”: if you can’t come up with good answers to these questions, you probably don’t have a highly promising product. On the other hand, if you conclude that you have a potential product for which people would pay money, you’re ready to take the next step: analyze the market to see whether you should go forward with the development of the product.
Key Takeaways
• An idea turns into a business opportunity when it has commercial potential—when you can make money by selling the product.
• Time utility provides value by having a product available at a convenient time.
• Place utility provides value by having a product available in a convenient location.
• Ownership utility provides value by transferring a product’s ownership.
• Form utility provides value by changing the composition of a product.
Exercise
(AACSB) Analysis
Provide two examples of each of the four types of utility: time, place, ownership, and form. Don’t use the examples given in the book.
Understand Your Industry
Learning Objective
1. Explain how to research an industry.
Before you invest a lot of time and money to develop a new product, you need to understand the industry in which it’s going to be sold. As inventor of the PowerSki Jetboard, Bob Montgomery had the advantage of being quite familiar with the industry that he proposed to enter. With more than twenty years’ experience in the water-sports and personal-watercraft industry, he felt at home in this business environment. He knew who his potential customers were, and he knew who his competitors were. He had experience in marketing similar products, and he was familiar with industry regulations.
Most people don’t have the same head start as Montgomery. So, how does the average would-be businessperson learn about an industry? What should you want to know about it? Let’s tackle the first question first.
Evaluating Your Industry
Before you can study an industry, you need to know what industry to study. An industry is a group of related businesses: they do similar things and they compete with each other. In the footwear industry, for example, firms make footwear, sell it, or both. Players in the industry include Nike and Adidas, both of which specialize in athletic footwear; but the industry is also sprinkled with companies like Candies (which sells young women’s fashion footwear) and Florsheim (quality men’s dress shoes).
Let’s say that you want to know something about the footwear industry because your potential purple cow is a line of jogging shoes designed specifically for older people (those over sixty-five) who live in the Southeast. You’d certainly need a broad understanding of the footwear industry, but would general knowledge be enough? Wouldn’t you feel more comfortable about pursuing your idea if you could focus on a smaller segment of the industry—namely, the segment that specializes in products similar to the one you plan to sell? Here’s a method that will help you narrow your focus.[20]
Segmenting Your Market
Begin with the overall industry—in this case, the footwear industry. Within this industry, there are several groups of customers, each of which is a market. You’re interested in the consumer market—retail customers. But this, too, is a fairly broad market; it includes everybody who buys shoes at retail. Your next step, then, is to subdivide this market into smaller market segments—groups of potential customers with common characteristics that influence their buying decisions. You can use a variety of standard characteristics, including demographics (age, sex, income), geography (region, climate, city size), and psychographics (lifestyle, activities, interests). The segment you’re interested in consists of older people (a demographic variable) living in the Southeast (a geographic variable) who jog (a psychographic variable). Within this market segment, you might want to subdivide further and find a niche—an unmet need. Your niche might turn out to be providing high-quality jogging shoes to active adults living in retirement communities in Florida.
The goal of this process is to identify progressively narrower sectors of a given industry. You need to become familiar with the whole industry—not only with the footwear industry but also with the retail market for jogging shoes designed for older people. You also need to understand your niche market, which consists of older people who live active lives in Florida.
Now that we know something about the process of focusing in on an industry, let’s look at another example. Suppose that your product idea is offering dedicated cruises for college students. You’d begin by looking at the recreational-activities industry. Your market would be people who travel for leisure, and within that market, you’d focus on the market segment consisting of people who take cruises. Your niche would be college students who want to take cruises.
Assessing Your Competition
Now that you’ve identified your industry and its various sectors, you’re ready to consider such questions as the following:[21]
• Is the industry growing or contracting? Are sales revenues increasing or decreasing?
• Who are your major competitors? How does your product differ from those of your competitors?
• What opportunities exist in the industry? What threats?
• Has the industry undergone recent changes? Where is it headed?
• How important is technology to the industry? Has it brought about changes?
• Is the industry mature, or are new companies successfully entering it?
• Do companies in the industry make reasonable profits?
Where do you find answers to questions such as these? A good place to start is by studying your competitors: Who are their customers? What products do they sell? How do they price their products? How do they market them? How do they treat their customers? Do they seem to be operating successfully? Observe their operations and buy their goods and services. Search for published information on your competitors and the industry. For example, there’s a great deal of information about companies on the Internet, particularly in company Web sites. The Internet is also a good source of industry information. Look for the site posted by the industry trade association. Find out whether it publishes a magazine or other materials. Talk with people in the industry—business owners, managers, suppliers; these people are usually experts. And talk with customers. What do they like or dislike about the products that are currently available? What benefits are they looking for? What benefits are they getting?
Key Takeaways
• Before developing a new product, you need to understand the industry in which it will be sold.
• An industry is a group of related businesses that do similar things and compete with each other.
• To research an industry, you begin by studying the overall industry and then progressively narrow your search by looking at smaller sectors of the industry, including markets (or groups of customers) and market segments (smaller groups of customers with common characteristics that influence their buying decisions).
• Within a market segment, you might want to subdivide further to isolate a niche, or unmet need.
Exercise
(AACSB) Analysis
To introduce a successful new service, you should understand the industry in which you’ll be offering the service. Select a service business that you’d like to run and explain what information you’d collect on its industry. How would you find it?
Forecasting Demand
Learning Objective
1. Forecast demand for a product.
It goes without saying, but we’ll say it anyway: without enough customers, your business will go nowhere. So, before you delve into the complex, expensive world of developing and marketing a new product, ask yourself questions like those in Figure 9.5 “When to Develop and Market a New Product”. When Bob Montgomery asked himself these questions, he concluded that he had two groups of customers for the PowerSki Jetboard: (1) the dealerships that would sell the product and (2) the water-sports enthusiasts who would buy and use it. His job, therefore, was to design a product that dealers would want to sell and enthusiasts would buy. When he was confident that he could satisfy these criteria, he moved forward with his plans to develop the PowerSki Jetboard.
Figure 9.5 When to Develop and Market a New Product
After you’ve identified a group of potential customers, your next step is finding out as much as you can about what they think of your product idea. Remember: because your ultimate goal is to roll out a product that satisfies customer needs, you need to know ahead of time what your potential customers want. Precisely what are their unmet needs? Ask them questions such as these:[22][23]
• What do you like about this product idea? What don’t you like?
• What improvements would you make?
• What benefits would you get from it?
• Would you buy it? Why, or why not?
• What would it take for you to buy it?
Before making a substantial investment in the development of a product, you need to ask yourself yet another question: are there enough customers willing to buy my product at a price that will allow me to make a profit? Answering this question means performing one of the hardest tasks in business: forecasting demand for your proposed product. There are several possible approaches to this task that can be used alone or in combination.
People in Similar Businesses
Though some businesspeople are reluctant to share proprietary information, such as sales volume, others are willing to help out individuals starting new businesses or launching new products. Talking to people in your prospective industry (or one that’s similar) can be especially helpful if your proposed product is a service. Say, for example, that you plan to open a pizza parlor with a soap opera theme: customers will be able to eat pizza while watching reruns of their favorite soap operas on personal TV/DVD sets. If you visited a few local restaurants and asked owners how many customers they served every day, you’d probably learn enough to estimate the number of pizzas that you’d serve during your first year. If the owners weren’t cooperative, you could just hang out and make an informal count of the customers.
Potential Customers
You can also learn a lot by talking with potential customers. Ask them how often they buy products similar to the one you want to launch. Where do they buy them and in what quantity? What factors affect demand for them? If you were contemplating a frozen yogurt store in Michigan, it wouldn’t hurt to ask customers coming out of a bakery whether they’d buy frozen yogurt in the winter.
Published Industry Data
To get some idea of the total market for products like the one you want to launch, you might begin by examining pertinent industry research. For example, to estimate demand for jogging shoes among consumers sixty-five and older, you could look at data published on the industry association’s Web site, National Sporting Goods Association, http://www.nsga.org/i4a/pages/index.cfm?pageid=1[24][25] Here you’d find that forty million jogging/running shoes were sold in the United States in 2008 at an average price of \$58 per pair. The Web site also reports that the number of athletes who are at least forty and who participate in road events increased by more than 50 percent over a ten year period.[26] To find more specific information—say, the number of joggers older than sixty-five—you could call or e-mail USA Track and Field. You might find this information in an eighty-seven-page statistical study of retail sporting-goods sales published by the National Sporting Goods Association (2011).[27] If you still don’t get a useful answer, try contacting organizations that sell industry data. American Sports Data, for instance, provides demographic information on no fewer than twenty-eight fitness activities, including jogging.[28] You’d want to ask them for data on the number of joggers older than sixty-five living in Florida. There’s a lot of valuable and available industry-related information that you can use to estimate demand for your product.
Now, let’s say that your research turns up the fact that there are three million joggers older than sixty-five and that six hundred thousand of them live in Florida, which attracts 20 percent of all people who move when they retire.[29] How do you use this information to estimate the number of jogging shoes that you’ll be able to sell during your first year of business? First, you have to estimate your market share: your portion of total sales in the older-than-sixty-five jogging shoe market in Florida. Being realistic (but having faith in an excellent product), you estimate that you’ll capture 2 percent of the market during your first year. So you do the math: 600,000 pairs of jogging shoes sold in Florida × 0.02 (a 2 percent share of the market) = 12,000, the estimated first-year demand for your proposed product.
Granted, this is just an estimate. But at least it’s an educated guess rather than a wild one. You’ll still want to talk with people in the industry, as well as potential customers, to hear their views on the demand for your product. Only then would you use your sales estimate to make financial projections and decide whether your proposed business is financially feasible. We’ll discuss this process in a later chapter.
Key Takeaways
• After you’ve identified a group of potential customers, your next step is finding out as much as you can about what they think of your product idea.
• Before making a substantial investment in the development of a product, you need to ask yourself: are there enough customers willing to buy my product at a price that will allow me to make a profit?
• Answering this question means performing one of the hardest tasks in business: forecasting demand for your proposed product.
• There are several possible approaches to this task that can be used alone or in combination.
• You can obtain helpful information about product demand by talking with people in similar businesses and potential customers.
• You can also examine published industry data to estimate the total market for products like yours and estimate your market share, or portion of the targeted market.
Exercise
(AACSB) Analysis
Your friends say you make the best pizzas they’ve ever eaten, and they’re constantly encouraging you to set up a pizza business in your city. You have located a small storefront in a busy section of town. It doesn’t have space for an eat-in restaurant, but it will allow customers to pick up their pizzas. You will also deliver pizzas. Before you sign a lease and start the business, you need to estimate the number of pizzas you will sell in your first year. At this point you plan to offer pizza in only one size.
Before arriving at an estimate, answer these questions:
1. What factors would you consider in estimating pizza sales?
2. What assumptions will you use in estimating sales (for example, the hours your pizza shop will be open)?
3. Where would you obtain needed information to calculate an estimate?
Then, estimate the number of pizzas you will sell in your first year of operations.
Breakeven Analysis
Learning Objective
1. Learn how to use breakeven analysis to estimate the number of sales units at which net income is zero.
Forecasting sales of shoes has started you thinking. Selling twelve thousand pair of shoes the first year you run the business sounds great, but you still need to find an answer to the all-important question: are there enough customers willing to buy my jogging shoes at a price that will allow me to make a profit? Is there some way to figure out the level of sales I would need to avoid losing money—to “break even”? Fortunately, an accountant friend of yours informs you that there is. Not surprisingly, it’s called breakeven analysis, and here’s how it works: to break even (have no profit or loss), total sales revenue must exactly equal all your expenses (both variable and fixed). To determine the level of sales at which this will occur, you need to do the following:
1. Fixed costs = \$210,000 salaries + \$60,000 rent + \$10,000 advertising + \$8,000 insurance + 12,000 other fixed costs = \$300,000
2. Variable cost per unit = \$40 (cost of each pair of shoes) + \$5 sales commission = \$45
3. Contribution margin per unit = \$80 selling price minus \$45 variable cost per unit = \$35
4. Breakeven in units = \$300,000 fixed costs ÷ \$35 contribution margin per unit = 8,571 units
Your calculation means that if you sell 8,571 pairs of shoes, you will end up with zero profit (or loss) and will exactly break even.
If your sales estimate is realistic (a big “if”), then you should be optimistic about starting the business. All your fixed costs will be covered once you sell 8,571 pairs of shoes. Any sales above that level will be pure profit. So, if you sell your expected level of twelve thousand pairs of shoes, you’ll make a profit of \$120,015 for the first year. Here’s how we calculated that profit:
• 12,000 expected sales level – 8,571 breakeven sales level = 3,429 units × \$35 contribution margin per unit = \$120,015 first-year profit
As you can see, breakeven analysis is pretty handy. It allows you to determine the level of sales that you must reach to avoid losing money and the profit you’ll make if you reach a higher sales goal. Such information will help you plan for your business.
Key Takeaways
• Breakeven analysis is a method of determining the level of sales at which the company will break even (have no profit or loss).
• The following information is used in calculating the breakeven point: fixed costs, variable costs, and contribution margin per unit.
• Fixed costs are costs that don’t change when the amount of goods sold changes. For example, rent is a fixed cost.
• Variable costs are costs that vary, in total, as the quantity of goods sold changes but stay constant on a per-unit basis. For example, sales commissions paid based on unit sales are a variable cost.
• Contribution margin per unit is the excess revenue per unit over the variable cost per unit.
• The breakeven point in units is calculated with this formula: fixed costs divided by contribution margin per unit (selling price per unit less variable cost per unit).
Exercise
(AACSB) Analysis
For the past ten years, you’ve worked at a PETCO Salon as a dog groomer. You’re thinking of starting your own dog grooming business. You found a place you could rent that’s right next to a popular shopping center, and two of your friends (who are also dog groomers) have agreed to work for you. The problem is that you need to borrow money to start the business and your banker has asked for a breakeven analysis. You have prepared the following cost estimates for your first year of operations:
Fixed Costs
Salaries \$105,000
Rent and utilities \$36,000
Advertising \$2,000
Equipment \$3,000
Variable Cost per Dog
Shampoo \$2.00
Coat conditioner \$1.50
Pet cologne \$0.75
Dog treats \$1.25
Hair ribbons \$0.50
You went online and researched grooming prices in your area. Based on your review, you have decided to charge \$32 for each grooming.
• Part 1:
• What’s the breakeven point in units—how many dogs will you need to groom in the first year to break even?
• If you and your two employees groomed dogs five days a week, seven hours a day, fifty weeks a year, how many dogs would each of you need to groom each day? Is this realistic given that it takes one hour to groom a dog?
• Part 2:
• If you raised your grooming fee to \$38, how many dogs would you need to groom to break even?
• At this new price, how many dogs will each of you have to groom each day (assuming, again, that the three of you groom dogs fifty weeks a year, five days a week, seven hours a day)?
• Part 3:
• Would you start this business?
• What price would you charge to groom a dog?
• How could you lower the breakeven point and make the business more profitable?
Product Development
Learning Objective
1. Describe the process of developing a product that meets customer needs.
Like PowerSki, every organization—whether it produces goods or provides services—sees Job 1 as furnishing customers with quality products. The success of a business depends on its ability to identify the unmet needs of consumers and to develop products that meet those needs at a low cost.[30] In other words, effective product development results in goods and services that can be sold at a profit. In addition, it results in high-quality products that not only satisfy consumer needs but also can be developed in a timely, cost-efficient manner. Accomplishing these goals entails a collaborative effort by individuals from all areas of an organization: operations management (including representatives from engineering, design, and manufacturing), marketing, accounting, and finance. In fact, companies increasingly assign representatives from various functional areas who work together as a project team throughout the product development processes. This approach allows individuals with varied backgrounds and experience to provide input as the product is being developed.
Product Development Is a Risky Proposition
Not surprisingly, developing profitable products is difficult, and the success rate is low. On average, for every successful product, a company has twelve failures. At this rate, the firms on the Fortune 1000 list waste over \$60 billion a year in research and development.[31] There are several reasons why product development is such a risky proposition:
• Trade-offs. You might, for instance, be able to make your jogging shoes lighter than your competitors’, but if you do, they probably won’t wear as well. They could be of higher quality, but that will make them more costly (they might price themselves out of the market).
• Time pressure. Developing a product can require hundreds of decisions that must be made quickly and with imperfect information.
• Economics. Because developing a product requires a lot of time and money, there’s always pressure to make sure that the project not only results in a successful product but also gets it to market at the most opportune time. Failure to be first to market with an otherwise desirable new product can cost a company a great deal of money.
Even so, organizations continue to dedicate immense resources to developing new products. Your supermarket, for example, can choose from about one hundred thousand items to carry on its shelves—including twenty thousand new products every year. Unfortunately, the typical supermarket can stock only thirty thousand products.[32]
Video Clip 9.1 10 Worst Product Flops
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=97
Even the mighty Coca-Cola has had its share of failures—New Coke, anyone?
The Product Development Process
The product development process is a series of activities by which a product idea is transformed into a final product. It can be broken down into the seven steps summarized in Figure 9.6 “The Product Development Process”.
Evaluate Opportunities and Select the Best Product Idea
If you’re starting your first business, you might have only one product idea. But existing organizations often have several ideas for new products, as well as improvements to existing ones. Where do they come from? They can come from individuals within the organization or from outside sources, such as customers. Typically, various ideas are reviewed and evaluated by a team of individuals, who identify the most promising ideas for development. They may rely on a variety of criteria: Does the proposed product fill an unmet need of our customers? Will enough people buy our product to make it commercially successful? Do we have the resources and expertise to make it?
Get Feedback to Refine the Product Concept
From the selected product idea, the team generates an initial product concept that describes what the product might look like and how it might work. Members talk both with other people in the organization and with potential buyers to identify customer needs and the benefits that consumers will get from the product. They study the industry in which the product will be sold and investigate competing products. They brainstorm various product designs—that is, the specifications for how the product is to be made, what it’s to look like, and what performance standards it’s to meet.
Based on information gathered through this process, the team will revise the product concept, probably pinpointing several alternative models. Then they’ll go back to potential customers and get their feedback on both the basic concept and the various alternatives. Based on this feedback, the team will decide what the product will look like, how it will work, and what features it will have.
Make Sure the Product Performs and Appeals to Consumers
The team then decides how the product will be made, what components it will require, and how it will be assembled. It will decide whether the product should be made in-house or outsourced to other companies. For products to be made in-house, the team determines where parts will be obtained. During this phase, team members are involved in design work to ensure that the product will be appealing, safe, and easy to use and maintain.
Design with Manufacturing in Mind
As a rule, there’s more than one way to make any product, and some methods are more expensive than others. During the next phase, therefore, the team focuses its attention on making a high-quality product at the lowest possible cost, working to minimize the number of parts and simplify the components. The goal is to build both quality and efficiency into the manufacturing process.
Build and Test Prototypes
A prototype is a physical model of the product. In the next phase, prototypes are produced and tested to make sure that the product meets the customer needs that it’s supposed to. The team usually begins with a preliminary prototype from which, based on feedback from potential customers, a more sophisticated model will then be developed. The process of building and testing prototypes will continue until the team feels comfortable that it has fashioned the best possible product. The final prototype will be extensively tested by customers to identify any changes that need to be made before the finished product is introduced.
Ramp Up Production and Run Market Tests
During the production ramp-up stage, employees are trained in manufacturing and assembly processes. Products turned out during this phase are carefully inspected for residual flaws. Samples are often demonstrated or given to potential customers for testing and feedback.
Launch the Product
In the final stage, the firm starts ongoing production and makes the product available for widespread distribution.
Key Takeaways
• The success of a business depends on its ability to identify the unmet needs of consumers and to develop products that meet those needs at a reasonable cost.
• Accomplishing these goals requires a collaborative effort by individuals from all areas of the organization: operations management (including representatives from engineering, design, and manufacturing), marketing, accounting, and finance.
• Representatives from these various functional areas often work together as project teams throughout the product development process, which consists of a series of activities that transform a product idea into a final product.
• This process can be broken down into seven steps:
1. Evaluate opportunities and select the best product mix
2. Get feedback to refine the product concept that describes what the product might look like and how it might work
3. Make sure that the product performs and appeals to consumers
4. Design with manufacturing in mind to build both quality and efficiency into the manufacturing process
5. Build and test prototypes, or physical models of the product
6. Run market tests and enter the ramp-up stage during which employees are trained in the production process
7. Launch the product
Exercise
(AACSB) Analysis
Use your imagination to come up with a hypothetical product idea. Now, identify the steps you’d take to design, develop, and bring your product to market.
Protecting Your Idea
Learning Objective
1. Learn how to protect your product idea by applying for a patent.
You can protect your rights to your idea with a patent from the U.S. Patent and Trademark Office, which grants you “the right to exclude others from making, using, offering for sale, or selling” the invention in the United States for twenty years.[33]
What do you need to know about applying for a patent? For one thing, document your idea as soon as you think of it. Simply fill out a form, stating the purpose of your invention and the current date. Then sign it and get someone to witness it. The procedure sounds fairly informal, but you may need this document to strengthen your claim that you came up with the idea before someone else who also claims it. Later, you’ll apply formally for a patent by filling out an application (generally with the help of a lawyer), sending it to the U.S. Patent and Trademark Office, and waiting. Nothing moves quickly through the U.S. Patent and Trademark Office, and it takes a long time for any application to get through the process.
Will your application get through at all? There’s a good chance if your invention meets all the following criteria:
• It’s new. No one else can have known about it, used it, or written about it before you filed your patent application (so keep it to yourself until you’ve filed).
• It’s not obvious. It has to be sufficiently different from everything that’s been used for the purpose in the past (you can’t patent a new color for a cell phone).
• It has utility. It can’t be useless; it must have some value.
Applying for a U.S. patent is only the first step. If you plan to export your product outside the United States, you’ll need patent protection in each country in which you plan to do business, and as you’ve no doubt guessed, getting a foreign patent isn’t any easier than getting a U.S. patent. The process keeps lawyers busy: during a three-year period, PowerSki International had to take out more than eighty patents on the PowerSki Jetboard. It still has a long way to go to match the number of patents issued to some extremely large corporations. Microsoft, for example, recently obtained its ten thousandth patent.[34]
Clearly, the patent business is booming. The U.S. Patent and Trademark Office issued more than a half million patents in 2010.[35] One reason for the recent proliferation of patents is the high-tech boom: over the last decade, the number of patents granted has increased by more than 50 percent.
Key Takeaways
• You can protect your rights to your idea with a patent from the U.S. Patent and Trademark Office.
• A patent grants you “the right to exclude others from making, using, offering for sale, or selling” the invention in the United States for twenty years.
• To be patentable, an invention must meet all the following criteria: it’s new (no one else can have known about it, used it, or written about it before you filed your patent application); it’s not obvious (it’s sufficiently different from everything that’s been used for the purpose in the past); and it has utility (it must have some value; it can’t be useless).
Exercise
(AACSB) Analysis
A friend of yours described a product idea she had been working on. It is a child’s swing set with a sensor to stop the swing if anyone walks in front of it. She came to you for advice on protecting her product idea. What questions would you need to ask her to determine whether her product idea is patentable? How would she apply for a patent? What protection would the patent give her? How long would the patent apply?
Cases and Problems
Learning on the Web (AACSB)
Breaking Even on Burgers
You and your business partner plan to open a gourmet burger restaurant. Your partner estimated the new business will sell a hundred fifty thousand burgers during its first year and a half of operations. You want to determine the number of burgers you must sell to break even during this period.
Here are the figures you know so far:
• The variable cost for each burger is \$0.97 each.
• The fixed cost of making burgers for eighteen months is \$140,000 (this includes costs such as rent, utilities, insurance).
• You will sell your burgers for \$1.99 each.
• At the \$1.99 per-unit selling price, how many burgers will you have to sell to break even?
Part 1: Using the previous information, manually calculate the breakeven number of burgers. How close is the breakeven number of burgers to your partner’s sales estimate of one hundred fifty thousand burgers? How confident are you that your restaurant will be profitable?
Part 2: Now, recalculate the breakeven number of burgers using a higher selling price. Pretend that your likely customers are burger fanatics and will pay \$2.79 for a burger (rather than \$1.99). Also pretend that the variable cost for each burger and your fixed costs won’t change (variable cost per burger is still \$0.97 and fixed costs are still \$140,000). Manually calculate the number of burgers you must sell to break even at this higher selling price. Are you now more confident that the business will succeed?
Part 3: Without recalculating breakeven, answer these two questions:
1. If the variable cost for each burger went down from \$0.97 to \$0.80 per burger (and your selling price stayed at \$1.99), would you need to sell more or fewer burgers to break even?
2. If fixed costs went down from \$140,000 to \$100,000 (and your selling price stayed at \$1.99 and variable cost per burger returned to \$0.97), would you need to sell more or fewer burgers to break even?
Career Opportunities
Being a “Big Idea” Person
Imagine a career in which you design the products people use every day. If you’re a “big idea” person, have an active imagination, have artistic flair, and possess the ability to understand how products function, then a career in product design and development might be for you. To learn what opportunities are available in this field, go to the Job Bank section of the Product Development and Management Association’s Web site (http://www.pdma.org/job_bank.cfm) and click on “View Posted Jobs.” Explore the various job openings by clicking on a position (to highlight it); and then clicking on the “View Job Details” button at the bottom of the screen. Find a position that interests you and look for answers to these questions:
1. What’s the job like?
2. What educational background, work experience, and skills are needed for the job?
3. What aspects of the job appeal to you? What aspects are unappealing?
4. Are you cut out for a career in product design and development? Why, or why not?
Ethics Angle (AACSB)
Who’s Getting Fat from Fast Food?
Product liability laws cover the responsibility of manufacturers, sellers, and others for injuries caused by defective products. Under product liability laws, a toy manufacturer can be held liable if a child is harmed by a toy that’s been marketed with a design flaw. The manufacturer can also be held liable for defects in marketing the toy, such as giving improper instructions on its use or failing to warn consumers about potential dangers. But what if the product isn’t a toy, but rather a fast-food kid’s meal? And what if the harm isn’t immediately obvious but emerges over time?
These questions are being debated in the legal and health professions (and the media). Some people believe that fast-food restaurants should be held responsible (at least in part) for childhood obesity. They argue that fast-food products—such as kids’ meals made up of high-calorie burgers, fried chicken fingers, French fries, and sugary soft drinks—are helping to make U.S. children overweight. They point out that while restaurant chains spend billions each year to advertise fast food to children, they don’t do nearly enough to warn parents of the dangers posed by such foods. On the other side of the debate are restaurant owners, who argue that they’re not the culprits. They say that their food can be a part of a child’s diet—if it’s eaten in moderation.
There’s no disputing that 15 percent of American children are obese and that fast-food consumption by children has increased by 500 percent since 1970. Most observers also accept the data furnished by the U.S. Surgeon General: that obesity in the United States claims some three hundred thousand lives a year and costs \$117 billion in health care. The controversy centers on the following questions:
1. Who really is to blame for the increase in obesity among U.S. children?
2. Under current consumer-protection laws, is fast-food marketing aimed at children misleading?
3. Should fast-food restaurants be held legally liable for the health problems associated with their products?
What’s your opinion? If you owned a fast-food restaurant, what action (if any) would you take in response to the charges leveled by critics of your industry?
Team-Building Skills (AACSB)
The Great Idea
Get together with members of your team and brainstorm ideas for a new-to-the-market product. Begin the brainstorming session by asking each person to write an idea on a sticky note. Post the idea and repeat the process four times. After the team has evaluated and discussed the ideas, all members should vote. Each gets ten votes, which can be placed on one idea or spread over many. Once the voting ends, add up the votes received by each idea and declare one idea the winner.
Write a group report that answers the following questions:
1. What is the idea?
2. How would the idea work?
3. Who would our customers be?
4. What unmet need does it fill?
The Global View (AACSB)
What to Do When the “False” Alarm Goes Off
If someone on the street tried to sell you a “Rolex” watch for \$20, you’d probably suspect that it’s a fake. But what about a pair of New Balance athletic shoes? How do you know they’re authentic? How can you tell? Often you can’t. Counterfeiters are getting so good at copying products that even experts have trouble telling a fake from the real thing. What if the counterfeit product in question was a prescription drug? Even worse, what if it had been counterfeited with unsterile equipment or contained no active ingredients?
How likely is it that you’ll buy a counterfeit product in the next year? Unfortunately, it’s very likely. To learn a little more about the global counterfeiting business, go to the BusinessWeek and Washington Post Web sites. Read the BusinessWeek article “Fakes!” (http://www.businessweek.com/magazine/content/05_06/b3919001_mz001.htm) and the Washington Post article “Counterfeit Goods That Trigger the ‘False’ Alarm” (http://www.highbeam.com/doc/1P2-4576.html). After you read these articles, answer the following questions:
1. How has the practice of counterfeiting changed over time? What factors have allowed it to escalate?
2. What types of products are commonly counterfeited, and why might they be unsafe? What counterfeit products are particularly dangerous?
3. How do the counterfeiters get goods onto the market? How can you reduce your chances of buying fake goods?
4. Why is counterfeiting so profitable? How can counterfeiters compete on price with those making the authentic goods? How do counterfeiters harm U.S. businesses?
5. What efforts are international companies and governments (including China) making to stop counterfeiters?
6. If you know that a product is fake, is it ethical to buy it?
1. Mike Mozart – Peeps – CC BY 2.0.
2. Coulter, M., Entrepreneurship in Action (Upper Saddle River, NJ: Prentice Hall, 2001), 9–11.
3. PowerSki’s Web site, About PowerSki International section, http://powerski.com/content/psi_index.php (accessed October 29, 2011).
4. Brainy Quote, Woody Allen Quotes, http://www.brainyquote.com/quotes/quotes/w/woodyallen121347.html (accessed November 9, 2008).
5. Coulter, M., Entrepreneurship in Action (Upper Saddle River, NJ: Prentice Hall, 2001), 9–11.
6. Thurm, S., and Joann S. Lublin, “Peter Drucker’s Legacy Includes Simple Advice: It’s All about the People,” Wall Street Journal (November 14, 2005, B1, http://home.ubalt.edu/tmitch/641/WSJ_com%20-%20Peter%20Drucker%27s%20Legacy.htm (accessed October 29, 2011).
7. Catalina, “New Product Launch Program,” Catalina, http://www.catalinaconnections.com/products/new_product_launch.html (accessed October 30, 2011).
8. Kotler, P., and Gary Armstrong, Principles of Marketing, 12th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 253.
9. Godin, S., Purple Cow: Transform Your Business by Being Remarkable (New York: Penguin Group, 2003).
10. Segway, “Discover the Segway HT Revolution,” Segway, http://www.segway.com/segway (accessed October 29, 2011)
11. Finder, “Segway HT,” The Great Idea Finder, http://www.ideafinder.com/history/inventions/story089.htm (accessed May 11, 2006).
12. The Great Idea Finder, “The JD Batball,” The Great Idea Finder, http://www.ideafinder.com/history/inventions/jdbatball.htm (accessed October 29, 2011).
13. SolidWorks Express, “Molds Designer Uses SolidWorks Software to Make 8-Year-Old’s Dream a Reality,” SolidWorks Express, http://www.solidworks.com/swexpress/jan/200201_feature_04.html (accessed October 29, 2011).
14. PowerSki Jet boards, “Awards and Media,” PowerSki Jet boards, http://www.powerski.com/content/psi_index.php (accessed October 29, 2011).
15. Eureka!Ranch, Eureka!Ranch at http://www.eurekaranch.com, (accessed October 29, 2011).
16. CNN Money, “Success Calls for Creativity,” CNN Money, February 4, 1997, http://money.cnn.com/1997/02/04/busunu/intv_hall (accessed October 29, 2011).
17. Eureka!Ranch, Eureka!Ranch at http://www.eurekaranch.com, (accessed October 29, 2011).
18. WalletPop, “Top 25 Biggest Product Flops of All Time,” http://www.dailyfinance.com/photos/top-25-biggest-product-flops-of-all-time/ (accessed October 29, 2011).
19. Kevin – bic – CC BY-NC-ND 2.0.
20. Allen, K., Entrepreneurship for Dummies (Foster, CA: IDG Books, 2001), 73–77.
21. Allen, K., Entrepreneurship for Dummies (Foster, CA: IDG Books, 2001), 73–77.
22. Ulrich, K., and Steven Eppinger, Product Design and Development, 2nd ed. (New York: Irwin McGraw-Hill, 2000), 66
23. Allen, K., Entrepreneurship for Dummies (Foster, CA: IDG Books, 2001), 79.
24. Running USA, “Running USA: Running Defies The Great Recession, Running USA’s State of the Sport 2010—Part II,” LetsRun.com, http://www.letsrun.com/2010/recessionproofrunning0617.php (accessed October 28, 2011)
25. National Sporting Goods Association, http://nsga.org (accessed October 28, 2011).
26. USA Track & Field, “Long Distance Running: State of the Sport,” USA Track & Field, http://www.usatf.org/news/specialReports/2003LDRStateOfTheSport.asp (accessed October 29, 2011).
27. National Sporting Goods Association, “Sporting Goods Market in 2010,” National Sporting Goods Association, http://www.nsga.org/i4a/pages/index.cfm?pageid=1 (accessed October 28, 2011).
28. American Sports Data, “Trends in U.S. Physical Fitness Behavior (1987–Present),” http://www.americansportsdata.com/phys_fitness_trends1.asp (accessed October 28, 2011).
29. Zagier, A. S., “Eyeing Competition, Florida Increases Efforts to Lure Retirees,” Boston Globe, December 26, 2003, http://www.boston.com/news/nation/articles/2003/12/26/eyeing_competition_florida_increases_efforts_to_lure_retirees (accessed October 28, 2011).
30. Ulrich, K., and Steven Eppinger, Product Design and Development, 2nd ed. (New York: Irwin McGraw-Hill, 2000), 3.
31. Ulwick, T., and John A. Eisenhauer, “Predicting the Success or Failure of a New Product Concept,” The Management Roundtable,http://www.roundtable.com/Event_Center/I@WS/I@WS_paper3.html (accessed May 11, 2006).
32. Hannaford, S., “Slotting Fees and Oligopolies,” http://www.oligopolywatch.com/2003/05/08.html (accessed May 11, 2006).
33. U.S. Patent and Trademark Office, http://www.uspto.gov/web/patents/howtopat.htm (accessed October 28, 2011).
34. Fried, I., “Microsoft Gets 10,000th Patent,” CNET News, http://news.cnet.com/8301-13860_3-10157884-56.html (accessed October 28, 2011).
35. U.S. Patent and Trademark Office, http://www.uspto.gov/web/patents/howtopat.htm (accessed October 28, 2011). | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/02%3A_Day-to-day_Operations/2.06%3A_Chapter_9-_Product_Design_and_Development.txt |
Simione Consultants LLC
Health care is the largest single industry in the US economy. Currently, health care represents nearly 17 percent of the gross domestic product, encompassing nearly 600,000 establishments and employing more than 14 million people. The health-care industry covers an extraordinary wide range of businesses and operations. It includes large hospitals, diagnostic laboratories, nursing care facilities, and the offices of doctors and dentists. Each establishment has individuals that possess considerable expertise in their respective disciplines. However, they may not possess the knowledge or the expertise that would enable them to manage their establishments in the most efficient manner. That is where firms like Simione Consultants LLC play a vital role.
Simione Consultants LLC represents the evolution of consulting companies that have spun off from many accounting firms. Accountants are no longer merely reconciling accounts or preparing tax returns for their clients. They are now offering a broad range of consulting services. Simione Consultants LLC provides expert assistance to hospital-based and hospital-affiliated home health and hospice agencies, visiting nurse associations, small proprietary agencies, and large national chains. They provide services that one might expect from a firm whose origins were in a standard accounting practice—such as assisting in accounts receivables and cash-flow management. Other accounting services that they provide include financial analysis reports and the preparation of cost reports for the federal government. They can conduct in-depth cost analyses at a detailed and a granular level so that clients can improve their operational efficiencies. The compliance division consulting services include working with health-care attorneys, corporate compliance and audit departments, and government agencies such as the Office of the Inspector General. Its clinical operations division works closely with financial consultants to improve the financial health of its clients.
What makes Simione Consultants LLC distinct is its ability to go beyond these basic accounting tasks and provide vital ancillary support for its clients in this niche market. They are in a position to conduct the valuation of businesses or assist in mergers and acquisitions. They help clients with preparing a prospectus or assisting with negotiations. Their consulting services can advise on how a client can maximize its return on an information management system by identifying system requirements and specifying possible solutions. In addition, the company has developed a software product—“The Financial Monitor”—that provides quarterly home health and hospice reports with multiple valuable benchmarks, including national, state, and profit-status norms, to help their clients and the industry make informed financial decisions.
A measure of how firms such as Simione Consultants LLC have moved beyond balance accounts is the company’s ability to support a client’s marketing function. The firm can help build comprehensive marketing plans and assist clients in developing and improving sales materials and training.
Simione Consultants LLC began its work in the home health-care industry more than forty years ago with an agency in Hamden, Connecticut. It was the vision of William J. Simione Jr., the founding member, who saw an opportunity. With his brother Robert J. Simione, the managing principal, and a dedicated team of principals, management, and staff, William Simione has helped Simione Consulting LLC become one of the leading home health and hospice consulting companies in the United States with over a thousand clients. Robert Simione says that a company is only as good as the people who work for it, and Simione Consultants LLC has the best home health and hospice consultants in the country.
Understanding the Need for Accounting Systems
Learning Objectives
1. Understand why a basic knowledge of accounting is important for a small business.
2. Understand the importance of selecting an accountant to enhance the overall operation of a business.
3. Define the two major approaches to accounting systems: cash versus accruals.
The older I get, the more interesting I find lawyers and accountants.
– Alex James
Imagine that you invite a friend from China, who is visiting the United States for the first time, to a baseball game. Your friend has never been to a baseball game before and knows nothing of the game’s rules. He might notice on the scoreboard listings for runs, hits, and errors. Your friend might also see notations on the number of strikes and balls. He does not know exactly what any of those terms mean, but he notices that some people in the stands applaud when the number of runs increases. Your friend might be amused by seeing individuals periodically running from one base to another; however, without knowing the basic rules of baseball, he cannot possibly understand what is actually occurring. He certainly could not comment on how well the game is going or provide suggestions about what one of the teams should do next. Most Americans would be in the same position if they were watching a cricket match. In both cases, you and your friend are in the same position of someone who wishes to run a business without having a fundamental understanding of accounting systems.
Warren Buffett has said that accounting is, to put it simply, the language of business. Without a fundamental understanding of this language of accounting and its set of rules, you are in the same position as your Chinese friend—you really do not know what is going on with a business. If someone is considering starting a business, he or she should possess some degree of fluency in this language. One does not expect this businessperson to be as knowledgeable as a certified public accountant (CPA) or an expert in tax issues. However, such businesspeople should have a clear expectation that they will be able to look at the key elements of an accounting system and interpret how well their businesses are doing. They should be able to track some of the key tasks and elements associated with a comprehensive accounting system.
Accounting is defined by the American Institute of Certified Public Accountants (AICPA) as “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.”[2] Put more simply, it is essentially an information system. Accounting provides critical information to potential investors and businesses managers. Accounting may, in fact, be one of the oldest information systems known to humans. Some have argued that accounting systems were the impetus for the development of writing systems in Mesopotamia. Archaeologists have discovered clay tokens, dating back 10,000 years ago, which functioned as part of the inventory system measuring agricultural goods, such as grains and domesticated animals. By 3500 BC, these tokens were being stored in containers—known as bullae. Notations on the surface of these containers indicated the type and quantity of the tokens held within; for many, this system was the basis of an abstract system of written communication.[5]
Other ancient societies recognized the importance of carefully monitoring and recording economic transactions. The Roman Empire needed to finance its operations and employed the familiar concept of an annual budget to coordinate expenditures and taxation. It had treasury managers, known as questors, who were subject to periodic audits.[6] The most famous monograph on accounting dates to Renaissance Italy. Luca Pacioli, a Franciscan friar and polymath, wrote Summa de Arithmetica, Geometria, Proportioni et Proportionalita in 1494. Essentially this was a math textbook, but it included a section on double-entry bookkeeping. This approach to accounting had been covered by Beredetto Cotrugli a century earlier.[7] The text was immediately recognized as an important contribution and was one of the first books produced by Gutenberg. On a first reading, Pacioli’s coverage appears to be remarkably “modern.” It described how merchants should identify their assets and liabilities, note transitions as they occur, and identify them as either debits or credits. He pointed out that the total of debits and credits must be equal, thus his model became the basis of the balance sheet. In the intervening five hundred years, business has essentially adapted Pacioli’s approach. Obvious, over the last five centuries, businesses have grown both in size and in complexity, and accounting systems have grown with them. Therefore, it is important for any business regardless of size to be able to “count” on solid accounting information.
The exact nature of accounting support will be greatly determined by the type and size of the small business. The level of accounting support required by the nonemployer business will obviously differ significantly from the level required by a business generating tens of millions of dollars of revenue and employing hundreds of workers. The level of support will also be influenced by the business owner’s familiarity with accounting and the type of accounting information systems that have been determined as appropriate. Regardless of size or type, small businesses should plan on eventually acquiring the talents of an accountant. Preferably, the decision to use an accountant should occur with the creation of the business.
Hiring an accountant or an accounting firm is an important decision for a small business. Employing an accountant does not translate into this individual being a full-time employee of the business. At the start, most small businesses will use the accountant as a consultant or a contract employee. As they grow, some small businesses might benefit from acquiring the services of full-service accounting firm. Although some start-ups, particularly those that might be cash-strapped, use the services of the bookkeeper only, but this is ill-advised. Most small businesses will need the services of a CPA. Another type of accountant a small business might employ is known as an enrolled agent. These are accountants who have passed a tax test from the Internal Revenue Service (IRS).
When looking for an accountant, there are some issues that you should consider. Try to find an accountant who has some working familiarity with a particular type of business or industry. Hopefully, you will be able to find an accountant with whom you have some rapport. This is important because a good accountant is more than simply someone who balances the books. You should consult an accountant before determining what type of accounting system you intend to employ—cash versus accrual (see Section 10.1 “Understanding the Need for Accounting Systems”). Remember that an accountant will play an important role in assisting you in the creation, purchase, and development of an accounting information system for the business. This system is important in providing the appropriate information to the external community (for this audience the term financial accounting is often used)—bankers, angel investors, venture capitalists, and/or the government. The same accounting information system will also be an important component of internal controls (in this case the term managerial accounting is used)—the systems and policies by which you make a firm more efficient. In this role, an accountant can help develop appropriate policies with respect to cash control and inventory control. An accountant can play a critical role in developing business plans, particularly with respect to budgets and financial statements. As highlighted in Section 10.3 “Financial Ratio Analysis”, you should consult an accountant before selecting an accounting software package. Quite often, an accountant can be extremely useful in training people to use such a software package.[8]
Video Clip 10.1 Why Warren Buffett Said Accounting Is the Language of Business
This video introduces the importance of accounting.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.2 Why You Need an Accountant
This video explains why a small business needs the services of a professional accountant.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.3 What CPAs Wish Every Small Business Knew
This video approaches small business’s need for accounting from the accountant’s perspective.
https://youtube.com/watch?v=R_FcOu2_SoA
Alternative Approaches to Accounting Systems
The system of double-entry bookkeeping is, perhaps, the most beautiful one in the wide domain of literature or science. If it were less known, it would be the admiration of the learned world.[9]
Edwin T. Freedley
The evolution of accounting has led to two major systems: the cash basis model and the accrual basis model. Before describing the two systems, we must identify a very important term—accounting transactions. When in business, we either receive money from a sale or spend money, such as in buying a piece of equipment. We can define these as transactions. The manner in which we record transactions defines the difference between a cash basis accounting system or an accrual accounting system.
In most cases, either system can be used by a business (there are situations under which a cash-based accounting system cannot be used, the details of which are discussed later), but regardless of the system used, a business must clearly specify which method is being employed.
In the cash-based accounting system, a transaction is recorded when money is either received or spent. As an example, a business has three sales on June 29 of a particular year. The first sale is for \$500, the second is for \$1,000, and the third is for \$300. However, the three customers use different methods of payment. The first customer pays for the product in cash, the second customer writes a personal check, and the third customer pays by credit card. The second customer’s personal check clears on July 5, while the credit card company transfers the \$300 into the business’s account on July 3. Under the cash basis accounting system, the business would list the first sale of \$500 as a June transaction, but it would list the second and third sales (totaling \$1,300) as July transactions. The same logic is used with respect to expenditures. If the same firm purchased a laptop computer in July but did not have to pay for two months, then the transaction would be recorded in September.
Under the accrual accounting system, transactions are recorded when they occur. If the aforementioned business was functioning under the accrual basis accounting system, then all three sales (totaling \$1,800) would be recorded as June transactions, and the purchase of the laptop would be designated as a July transaction.
Generally, though, with some few exceptions, businesses must use the accrual basis accounting method if they have inventory of any component of items that they sell to the public and if the sales are more than \$5 million per year. Other conditions under which the cash basis accounting system may not be used include C corporations, partnerships with at least one C corporation partner, and tax shelters.[10] The major benefit of cash basis accounting is its simplicity. It greatly reduces the demand on bookkeeping. The cash basis system also provides a much more accurate indication of a company’s current cash position. This approach may be used to affect taxable income, which can be done by deferring billing so that payments are received in the next year.[11] However, there are drawbacks to the cash basis approach—the most serious being that it may provide a distorted or an inaccurate indication of profitability. The reality is that cash basis accounting systems are really only appropriate for businesses with sales under \$1 million and that function basically on a cash basis.
Accrual basis accounting is in conformance with IRS and generally accepted accounting principles (GAAP) regulations. Although more complex and generally requiring greater bookkeeping with a more sophisticated approach to accounting, the accrual basis provides a more accurate indication of the profitability of a business. The major drawback of the accrual basis system comes with respect to understanding the business’s cash position. A firm may look profitable under this system, but if customers have not paid for the goods and services, the cash position might be dire.[12] A summary of the pros and cons of the two systems is provided in Figure 10.1 “Comparative Accounting Systems”.
Video Clip 10.4 Accrual versus Cash-Basis Accounting Video Presentation
A lecture on the two accounting systems.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.5 Accrual Basis versus Cash Basis Accounting Power
A video with voice-over of a PowerPoint presentation.
https://youtube.com/watch?v=3RxJFyUPu_o
Key Takeaways
• Accounting is one of the oldest activities of human civilizations and dates back over five thousand years.
• Small businesses require accounting capabilities, which must be done either in-house or through an external service.
• The selection process for an accounting service should be carefully considered. The evaluation process should consider the following: expertise in a particular type of business or industry, rapport, availability of additional consulting services, and the ability to support computerized accounting systems.
• Accounting systems may be divided into two major types: cash basis and accrual basis.
• Cash basis systems count a transaction when the cash is received. Such systems are used by smaller businesses that have no appreciable inventory.
• Accrual basis systems count transactions when they occur. Although this system may require additional analysis to determine a business’s actual cash position, it provides a more accurate measure of profitability.
Exercises
1. Identify five local businesses and talk to their owners. Ask them about how they handle their accounting needs. Do they do it all themselves or do they use an accountant or an accounting service? If they use an accountant or an accounting service, ask them in what way—merely to prepare taxes or do they draw on them for other advice?
2. Identify five local accountants or accounting firms. Ask them about the services that they provide to small businesses. If possible, try to determine the cost of these services.
3. Ask the five local businesses which system they use—cash or accrual—and why they use it.
Financial Accounting Statements
Learning Objectives
1. Understand what is measured on a balance sheet.
2. Understand the term depreciation.
3. Understand what goes on an income statement.
4. Understand what is measured in a cash-flow statement.
5. Appreciate the importance of forecasting when developing a cash-flow projection statement.
It sounds extraordinary, but it’s a fact that balance sheets can make fascinating reading.[13]
Mary, Lady Archer of Weston
All business plans should contain sets of financial statements. However, even after the initial business plan is created, these financial statements provide critical information that will be required for the successful operation of the business. They not only are necessary for tax purposes but also provide critical insights for managing the firm and addressing issues such as the following:
• Are we profitable?
• Are we operating efficiently?
• Are we too heavily in debt or could we acquire more debt?
• Do we have enough cash to continue operations?
• What is this business worth?
There are three key financial statements: the balance sheet, the income statement, and the cash-flow statement. Every business owner or manager needs to be able to correctly interpret these statements if he or she expects to continue successful operations. It should be pointed out that all three financial statements follow general formats. The degree of detail or in some cases terminology may differ slightly from one business to another; as an example, some firms may wish to have an extensive list of operational expenses on their income statements, while others would group them under broad categories. Likewise, privately held businesses would not use the term shareholders’ equity but rather use owner’s equity in their balance sheet, and they would not list dividends. This aim of this chapter is to provide the reader with a broad overview of accounting concepts as they apply to managing small and mid-sized businesses.
The Balance Sheet Statement
One should think of the balance sheet statement as a photograph, taken at a particular point in time, which images the financial position of a firm. The balance sheet is dominated by what is known as the accounting equation. Put simply, the accounting equation separates what is owned from who owns it. Formally, the accounting equation states the following:
assets = liabilities + owner’s equity.
Assets are “economic resources that are expected to produce a benefit in the future.”Liabilities are the amount of money owed to outside claims (i.e., money owed to people outside the business). Owner’s equity —also known as stockholders’ equity—represents the claims on the business by those who own the business. As specified in the accounting equation, the dollar value of assets must equal the dollar value of the business’s liabilities plus the owner’s equity. Before proceeding with any numerical example, let us define some important terms.
Current assets are assets that will be held for less than one year. They include cash, marketable securities, Accounts receivables, Prepaid expenses, and inventory. These are listed in a specific order. The order is based on the degree of liquidity of each asset. Liquidity measures the ease in which an asset can be converted into cash. Naturally, cash is the most liquid of all assets. All firms should have cash readily available. The exact amount of the desirable amount of cash to be held at hand will be determined by the sales level of the anticipated cash receipts and the cash needs of the business.
Marketable securities are stocks and bonds that a business may hold in the hope that they would provide a greater return to the business rather than just letting cash “sit” in a bank account. Most of these securities can be easily turned into cash—should the need arise.
Accounts receivables represent the amount of money due to a business from prior credit sales. Not all firms operate on a strictly cash sales basis. Many firms will offer customers the opportunity to purchase on a credit basis. As an example, a furniture store sells a bedroom set worth \$6,000 to a newlywed couple. The couple puts down \$2,500 to fix the sale and then signs a contract to pay the remaining \$3,500 within the next year. That \$3,500 would be listed as accounts receivable for the furniture firm.
Prepaid expense is an accrual accounting term that represents a payment that is made in advance of their actual occurrence. Insurance would be an example of a prepaid expense because a company is paying premiums to cover damages that might occur in the near future. If a year’s worth of rent were paid at one time, it too would be viewed as a prepaid expense.
Inventory is the tangible goods held by a business for the production of goods and services. Inventory can fall into three categories: raw materials, work-in-process (WIP), and finished goods. Raw materials inventory represents items or commodities purchased by a firm to create products and services. WIP inventory represents “partially completed goods, part or subassemblies that are no longer part of the raw materials inventory and not yet finished goods.”[15] The valuation of WIP should include the cost of direct material, direct labor, and overhead put into the WIP inventory. Finished inventory represents products that are ready for sale. Generally accepted accounting principles (GAAP) require that a business value its inventory on either the cost price or the market price—whichever is lowest. This inherent conservative approach to valuation is due to the desire to prevent the overestimation of inventory during inflationary periods.
Total current assets are the summation of the aforementioned items and are defined as follows:
total current assets = cash + marketable securities + accounts receivable + prepaid expenses + inventory.
The next set of items in the asset section of the balance sheet is long-term assets. Long-term assets are those assets that will not be turned into cash within the next year. Long-term assets may include a category known as investments. These are items that management holds for investment purposes, and they do not intend to “cash in” within the upcoming year. They might consist of other companies’ stock, notes, or bonds. In some cases, they may represent specialized forms—money put away for pension funds. The next major category of long-term assets is fixed assets. Fixed assets include plant, equipment, and land. Generally, these are valued at their original cost. The value of these assets will decline over time. As an example, you purchase a new car for \$25,000. If you were to sell the same car one, two, or five years later, its value would be less than the original purchase price. This recognition is known as depreciation which is a noncash expense that specifically recognizes that assets decline in value over time. Accumulated depreciation is a running total of all depreciation on assets. Depreciation is also found on the income statement. Its presence in that financial statement enables a business to reduce its taxable income. There are many methods by which you can compute the depreciation value on fixed assets. These methods can be split into two broad categories: straight-line depreciation and accelerated depreciation. Straight-line depreciation is fairly easy to illustrate. In the example of the car, assume you purchased this car for company use. You intend to use it for five years, and at the end of the five years, you plan on scrapping the car and expect that its salvage value will be zero. This is illustrated in Table 10.1 “Depreciation Calculations”.
Table 10.1 Depreciation Calculations
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Depreciation \$0 \$5,000 \$5,000 \$5,000 \$5,000 \$5,000
Accumulated depreciation \$0 \$5,000 \$10,000 \$15,000 \$20,000 \$25,000
Net asset value \$25,000 \$20,000 \$15,000 \$10,000 \$5,000 \$0
Because the useful lifetime of the vehicle was five years, the original value of the vehicle was divided by five; therefore, the annual depreciation would equal \$5,000 (\$25,000/5 = \$5,000 per year). The accumulated depreciation simply sums up the prior years’ depreciation for that particular asset.
Accelerated depreciation methods attempt to recapture a major portion of the depreciation earlier in the life of an asset. Accelerated depreciation yields tax-saving benefits earlier in the life of any particular fixed asset. The appropriate method of depreciating an asset for tax purposes is dictated by the Internal Revenue Service (IRS). One should look at the IRS publication 946—How to Depreciate Property—to get a better understanding of the concept of depreciation and how to properly compute it.
The last category of long-term assets is intangible assets —assets that provide economic value to a business but do not have a tangible, physical presence. Intangible assets include items such as patents, franchises, copyrights, and goodwill. Thus the value of long-term assets can be calculated as follows:
long-term assets = investments + fixed assets − accumulated depreciation + intangible assets.
The last element on the asset side of the balance sheet is the total assets. This is the summation of current assets and long-term assets.
On the other side of the balance sheet, we have liabilities plus owner’s equity. The elements of liabilities consist of current liabilities and long-term liabilities. These represent what a business owes to others. Current liabilities are debts and obligations that are to be paid within a year. These include notes payable, Accounts payable, other items payable (e.g., taxes, wages, and rents), dividends payable, and the current portion of long-term debt. In equation form,
current liabilities = notes payable + accounts payable + other items payable + dividends payable + the current portion of long-term debt.
Notes payable represents money that is owed and which must be repaid within a year. It is fairly inclusive because it may include lines of credit from banks that have been used, short-term bank loans, mortgage obligations, or payments on specific assets that are due within a year.
Accounts payable are short-term obligations that a business owes to suppliers, vendors, and other creditors. It may consist of all the supplies and materials that were purchased on credit.
Other items payable can include items such as the payroll and tax withholdings owed to employees or the government but which have not as of yet been paid.
Dividends payable is a term that is appropriate for businesses structured as corporations. This category represents the amount that a business plans to pay its shareholders.
The current portion of long-term debt represents how much of the long-term debt must be repaid within the upcoming fiscal year. This would include the portion of the principal that is due in this fiscal year.
The other portion of liabilities is represented by long-term liabilities. These are debts payable over a period greater than one year and include long-term debt, pension fund liability, and long-term lease obligations. In equation form,
long-term liabilities = long-term debt + pension fund liabilities + long-term lease obligations.
Total liabilities is the sum of current liabilities and long-term liabilities.
The other major component of the right-side of the balance sheet is owner’s (or stockholders’) equity. Owner’s equity represents the value of the shareholders’ ownership in a business. It is sometimes referred to as net worth. It may be composed of items such as paid in capital and retained earnings. Paid in capital is the amount of money provided by investors through the issuance of common or preferred stock.[16]Retained earnings is the cumulative net income that has been reinvested in a business and which has not been paid out to shareholders as dividends.[17]
The entire balance sheet and its calculations are summarized in Figure 10.2 “The Balance Sheet”.
Figure 10.2 The Balance Sheet
In Table 10.2 “Acme Enterprises’ Balance Sheet, 2005–2010 (\$ Thousands)”, we provide six years’ worth of balance sheet statements for a hypothetical small business—Acme Enterprises. It is obviously important to have such information, but what exactly might this tell us in terms of the overall success and operation of the business? We will return to these statements in Section 10.3 “Financial Ratio Analysis” to show how those questions can be addressed with ratio analysis.
Table 10.2 Acme Enterprises’ Balance Sheet, 2005–2010 (\$ Thousands)
December 31
Assets 2005 2006 2007 2008 2009 2010
Cash and marketable securities \$30.0 \$32.3 \$34.7 \$37.3 \$40.1 \$43.1
Accounts receivable \$100.0 \$107.5 \$115.6 \$124.2 \$133.5 \$143.6
Inventories \$70.0 \$75.3 \$80.9 \$87.0 \$93.5 \$100.5
Other current assets \$90.0 \$96.8 \$104.0 \$111.8 \$120.2 \$129.2
Total current assets \$290.0 \$311.8 \$335.1 \$360.3 \$387.3 \$416.3
Property, plant, and equipment—gross \$950.0 \$1,154.5 \$1,387.2 \$1,654.6 \$1,958.1 \$2,306.2
Accumulated depreciation \$600.0 \$695.0 \$810.5 \$949.2 \$1,114.6 \$1,310.4
Property, plant, and equipment—net \$350.0 \$459.5 \$576.7 \$705.4 \$843.5 \$995.7
Other noncurrent assets \$160.0 \$176.0 \$193.6 \$213.0 \$234.3 \$257.7
Total assets \$800.0 \$947.3 \$1,105.5 \$1,278.6 \$1,465.1 \$1,669.7
Liabilities
Accounts payable \$91.0 \$97.8 \$105.2 \$113.0 \$121.5 \$130.6
Short-term debt \$150.0 \$177.5 \$216.3 \$264.2 \$328.1 \$406.0
Other current liabilities \$110.0 \$118.3 \$127.1 \$136.7 \$146.9 \$157.9
Total current liabilities \$351.0 \$393.6 \$448.6 \$513.9 \$596.5 \$694.6
Long-term debt \$211.0 \$211.0 \$211.0 \$211.0 \$211.0 \$211.0
Deferred income taxes \$50.0 \$53.8 \$57.8 \$62.1 \$66.8 \$71.8
Other noncurrent liabilities \$76.0 \$81.7 \$87.8 \$94.4 \$101.5 \$109.1
Total liabilities \$688.0 \$740.0 \$805.2 \$881.4 \$975.8 \$1,086.5
Paid in capital \$— \$— \$— \$— \$— \$—
Retained earnings \$112.0 \$207.3 \$300.3 \$397.2 \$489.3 \$583.3
Total owner’s equity \$112.0 \$207.3 \$300.3 \$397.2 \$489.3 \$583.3
Total liabilities + owner’s equity \$800.0 \$947.3 \$1,105.5 \$1,278.6 \$1,465.1 \$1,669.7
Video Clip 10.6 Beginner’s Guide to Financial Statements: Balance Sheets
An introduction to the balance sheet.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.7 What Is the Balance Sheet?
A voice-over PowerPoint presentation describing the balance sheet. Be aware that this is seven minutes long.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.8 Balance Sheet: How to Explain How a Balance Sheet Works
Another description of the balance sheet.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
The Income Statement
Whereas the balance sheet looks at a firm at a particular point (date) in time, the income statement examines the overall profitability of a firm over a particular length or period of time. Normally, there are several time periods that may be used: fiscal year, fiscal quarter, or monthly. The income statement is also known as a profit and loss statement. It identifies all sources of revenues generated by a business and all the expenses incurred. The income statement provides the best insight into whether a business is profitable.
The income statement begins by identifying the sales or income for the designated period of time. Sales would be all the revenues derived from all the products and services sold during that time. The term income is sometimes used and represents all revenues and additional incomes produced by a business during the designated period. The next item in the income statement is the cost of goods sold (COGS), which is composed of all costs associated with the direct production of goods and services that were sold during the time period. It would include the costs of the raw materials used to produce the goods and those costs associated with production, such as direct labor. With these two values, the first measure of profit—gross profit —can be calculated:
gross profit = income − COGS.
The next element in the income statement is operating expenses —expenses that are incurred during the normal operation of a business. Operating expenses can be broken down into four broad categories: selling expenses, general and administrative expenses, depreciation, and other overhead expenses. Selling expenses would include all salaries and commissions paid to the business’s sales staff. It would also include the cost of promotions, advertising expenses, and other sales expenditures. Promotion costs might consist of costs associated with samples or giveaways. Advertising expenses would include all expenditures for print, radio, television, or Internet ads. Other sales expenditures would include money spent on meals, travel, meetings, or presentations by the sales staff. General and administrative expenses are those associated with the operation of a business beyond COGS and direct-selling expenses. Expenditures in this category would include salaries of office personnel, rent, and utilities. Depreciation was covered in the previous subsection. The balance sheet has a component designated accumulated depreciation. This is the summation of several years’ worth of depreciation on assets. In the income statement, depreciation is the value for a particular time period. If you look back in Table 10.1 “Depreciation Calculations”, the annual depreciation on the vehicle was \$5,000. If a business was developing an income statement for one particular year, then the depreciation would be listed as \$5,000. It is a noncash expenditure expense. The last component of operating expenses would be other overhead costs—a fairly generic category that may include items such as office supplies, insurance, or a variety of services a business might use. Having identified all the components of operating expenses, one is now in a position to compute a second measure of profitability—operating profit, which is sometimes referred to as earnings before interest and taxes (EBIT):
operating profit (EBIT) = gross profit − operating expenses.
The next section of the income statement is designated other revenues and expenses. This segment would include other nonoperational revenues (such as interest on cash or investments) and interest payments on loans and other debt instruments. When the other revenues and expenses are subtracted from the operating profit, one is left with earnings before taxes (EBT), Operating profit minus other revenue and expenses.:
EBT = operating profit − other revenues and expenses.
Taxes are then computed on the EBT and then subtracted. This includes all federal, state, and local tax payments that a business is obligated to pay. This brings us to our last measure of profitability—net profit, EBT minus taxes.:
net profit = EBT − taxes.
If a business does not pay out dividends, the net profit becomes an addition to retained earnings. The format of the income statement is summarized in Figure 10.3 “The Income Statement”. The income statement is the item that most individuals look at to determine the success of business operations. In Table 10.3 “Acme Enterprises’ Income Statement, 2005–10 (\$ Thousands)”, the income statements for Acme Enterprises are given for the period 2005 to 2010.
Table 10.3 Acme Enterprises’ Income Statement, 2005–10 (\$ Thousands)
2005 2006 2007 2008 2009 2010
Sales \$1,000.0 \$1,075.0 \$1,155.6 \$1,242.3 \$1,335.5 \$1,435.6
COGS \$500.0 \$537.5 \$566.3 \$608.7 \$641.0 \$689.1
Gross operating profit \$500.0 \$537.5 \$589.4 \$633.6 \$694.4 \$746.5
Selling and general administrative expenses \$250.0 \$268.8 \$288.9 \$310.6 \$333.9 \$358.9
Depreciation \$95.0 \$115.5 \$138.7 \$165.5 \$195.8 \$230.6
Other net (income)/expenses \$0.0 \$0.0 \$0.0 \$0.0 \$0.0 \$0.0
EBIT \$155.0 \$153.3 \$161.7 \$157.5 \$164.8 \$157.0
Interest income \$2.1 \$2.3 \$2.4 \$2.6 \$2.8 \$3.0
Interest expense \$10.5 \$12.4 \$15.1 \$18.5 \$23.0 \$28.4
Pretax income \$146.6 \$143.1 \$149.0 \$141.7 \$144.6 \$131.6
Income taxes \$51.31 \$50.10 \$52.16 \$49.58 \$50.61 \$46.06
Net income \$95.29 \$93.04 \$96.87 \$92.08 \$93.99 \$85.54
Dividends \$— \$— \$— \$— \$— \$—
Addition to retained earnings \$95.29 \$93.04 \$96.87 \$92.08 \$93.99 \$85.54
Video Clip 10.9 What Is the Income Statement?
A basic introduction to income statements.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.10 Income Statement
A further description of an income statement.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
The Cash-Flow Statement
Customer satisfaction, employee satisfaction and cash flow the three most important indicators for business.[18]
Jack Welch
The third component of financial statements is the cash-flow statement. There are two types of cash-flow statements—one examines cash flows for a given period (historic), and the other is a projection of future cash flows. The historic cash-flow statement is similar to the income statement in that it looks at cash inflows and cash outflows for a business during a specified period of time. Like the income statement, these periods of time can be the fiscal year, the fiscal quarter, or a month. The cash-flow projections statement attempts to identify cash flows into a firm and cash flows from a firm for some future period. This projection is extremely important because it may identify future subperiods in which a firm is producing a negative cash flow—where cash outflows exceed cash inflows.
From the standpoint of a small business owner, cash-flow statements provide insight into where cash flows are coming and going. The cash-flow projections statement may be the most important component of all the financial statements. Its importance stems from the fact that the flow of cash into a firm may not be synchronized with its cash outflows. Should there be a significant mismatch with cash outflows being significantly higher than cash inflows, a business may be in great difficulty with respect to meeting its current obligations, such as payroll, paying suppliers, and meeting short-term creditors. As we will see, cash-flow projection statements require several forecasts. These are discussed later in this section.
At some point, many businesses will experience negative cash flow. In fact, a negative cash flow is quite common in start-up operations and high-growth businesses where there is a pressing need for capital expenditures, research and development expenditures, and other significant cash outflows. One can also see the recurring presence of negative cash flows in businesses with seasonal sales. Negative cash flows can be covered by short-term borrowing. However, this type of borrowing brings up two important issues. First, any type of borrowing raises the overall debt level of a business, which might have an impact on the interest rate on the debt. Second, when a negative cash flow exists either because of an unforeseen exigency or because a business owner has failed to properly conduct a cash-flow projection analysis, a lender might look at a business in a jaundiced manner, which could have long-term consequences for a business.
A careful examination of the cash-flow statement could illustrate a point that has been mentioned several times in this book: there can be a significant difference between positive cash flow and profit. In looking at the income statement, one could find a positive net income (profit) and then examine the cash-flow statement and discover that a business has a significant negative cash flow. The cash-flow statement specifically maps out where cash is flowing into a firm and where it flows out. A properly developed cash-flow statement will show if a business will be generating enough cash to continue operations, whether it has sufficient cash for new investments, and whether it can pay its obligations. As previously stated, many of the uninitiated will look singularly at profits, while those who have greater expertise in business will always believe that cash is king.
As a way of visualization, the cash-flow statement bears some similarity to the bank statement you may receive at the end of the month. A bank statement shows the beginning cash balance, deposits (cash inflows), and checks you have written (cash outflows) for that month. Hopefully, you have a positive cash flow—cash inflows are greater than cash outflows—and you have not bounced any checks. Unlike the bank statement, the cash-flow statement is broken into three major categories: operations, financing, and investing. Cash flow from operations examines the cash inflows from all revenues, plus interest and dividend payments from investments held by a business. It then identifies the cash outflows for paying suppliers, employees, taxes, and other expenses. Cash flow from investing examines the impact of selling or acquiring current and fixed assets. Cash flow from financing examines the impact on the cash position from the changes in the number of shares and changes in the short and long-term debt position of a firm.
Cash inflows from operating activities consist of the following:
• Cash derived from the sale of goods or services
• Cash derived from accounts receivable
• Any cash derived from interest or dividends
• Any other cash derived that is not identified with financing or investments
The cash outflows from operating activities consist of the following:
• Cash outlays for goods purchased in the creation of goods and services
• Cash outlays for payment to suppliers
• Cash outlays to employees
• Cash paid for taxes or interest paid to creditors
Financing focuses on the cash flows associated with debt or equity. Some of the cash inflows associated with financing activities consist of the following:
• Cash from the sale of a company’s stock
• Cash received from borrowing (debt)
Cash outflows associated with financing consist of the following:
• Cash outlays to repay principal on long- and short-term debt
• Cash outlays to repurchase preferred stocks
• Cash outlays to pay for dividends on either common or preferred stock
The third category is investing. The sources of cash flow from investing activities consist of the following:
• Cash received from the sale of assets
• Cash received from the sale of equity investments
• Cash received from collections on a debt instrument
Cash outflows associated with investing activities consist of the following:
• Cash outlays to acquire a debt instrument of another business
• Cash payments to buy equity interest in other businesses
• Cash outlays to purchase a productive asset
A schematic of the cash-flow statement’s three areas of analysis is presented in Figure 10.4 “Cash Flow Breakdown”.
Figure 10.4 Cash Flow Breakdown
Cash-flow projection statements are about the state of future cash flows, which means they require forecasts. This translates into multiple forecasts—sales forecasts, forecasts of expenses, forecasts for necessary investments, and forecasts for a business’s financing requirements.
The most common approach for cash-flow forecasting in small businesses centers on projections of cash receipts and disbursements. These projections are often based on recent past data. We will demonstrate—shortly—this approach through an extensive example. This approach is generally limited to short and midterm forecasts (i.e., three to twelve months). There are other approaches to cash-flow forecasting; however, given the relative complexity of these approaches, they are often used only by larger and more sophisticated businesses. These other approaches include the adjusted net income method, the pro forma balance sheet method, and the accrual reversal method.[19]
The concept of cash-flow projection forecasting can be illustrated by using an example. Alex McLellan runs Soft Serve Services—a business that repairs and services soft-serve ice cream machines. His clients include ice cream parlors, resorts, and outlets at malls. Alex is a former engineer and somewhat methodical in developing his calculations for future budgets. He will be operating on the assumption that his business will be limited to his current locale. Alex has followed the same pattern for forecasting cash flows for years. First, he gathers together from his records his monthly and annual sales for the last five years, which are provided in Table 10.4 “Sales Data for Soft Serve Services”.
Table 10.4 Sales Data for Soft Serve Services
2006 2007 2008 2009 2010
January \$20,135 \$20,562 \$21,131 \$22,657 \$23,602
February \$19,545 \$19,739 \$19,852 \$22,154 \$22,307
March \$24,451 \$24,360 \$24,594 \$26,361 \$27,590
April \$22,789 \$23,374 \$24,000 \$26,220 \$32,968
May \$25,986 \$28,531 \$27,099 \$30,057 \$34,834
June \$28,357 \$30,468 \$32,893 \$34,168 \$37,078
July \$32,650 \$35,307 \$36,830 \$40,321 \$46,899
August \$34,488 \$37,480 \$40,202 \$44,890 \$52,042
September \$26,356 \$27,909 \$29,317 \$32,917 \$33,309
October \$24,211 \$22,795 \$23,719 \$24,339 \$25,691
November \$21,722 \$22,272 \$22,147 \$23,080 \$23,466
December \$22,017 \$22,454 \$28,321 \$30,468 \$33,583
Annual sales \$302,706 \$315,252 \$330,105 \$357,631 \$393,368
Using these data, Alex was able to calculate the growth rate in sales for the last four of the five years. As an example:
growth rate 2007 = (sales 2007 − sales 2006) / (sales 2006) = (\$315,252 − \$302,706) / (\$302,706) = (\$12,546) / (\$302,706) = 4.14 percent.
Although the average of the four annual growth rates was 6.8 percent (the annual growth rates were 4.14 percent in 2007, 4.71 percent in 2008, 8.34 percent in 2009, and 9.99 percent in 2010, thus having an average of 6.8 percent), Alex believes that the last two years were unusually good, and the growth rate for 2011 would be slightly lower at a rate of 6.5 percent. This rate of growth would mean that his estimate for sales in 2011 would be \$418,937, which comes from the following:
annual sales 2011 = annual sales 2010 × (1 + growth rate 2011) = \$393,368 × (1.065).
He knows from experience that his sales are quite seasonal, as illustrated in Figure 10.5 “Seasonality in Sales”. Alex believes that there is a high degree of consistency in this seasonality of sales across the years. So he computes (using a spreadsheet program) what percentage of annual sales occurs in each month. This calculation for January 2006 would be given as follows:
percentage of annual sales for January 2006 = (January 2006 sales) / (annual sales 2006) = (\$20,135) / (\$302,706) = 6.65 percent.
His analysis for each month in each of the five years is provided in Table 10.5 “Monthly Sales as a Percentage of Annual Sales”, as are the averages for each month.
Table 10.5 Monthly Sales as a Percentage of Annual Sales
2006 (%) 2007 (%) 2008 (%) 2009 (%) 2010 (%) Average (%)
January 6.65 6.52 6.40 6.34 6.00 6.38
February 6.46 6.26 6.01 6.19 5.67 6.12
March 8.08 7.73 7.45 7.37 7.01 7.53
April 7.53 7.41 7.27 7.33 8.38 7.59
May 8.58 9.05 8.21 8.40 8.86 8.62
June 9.37 9.66 9.96 9.55 9.43 9.60
July 10.79 11.20 11.16 11.27 11.92 11.27
August 11.39 11.89 12.18 12.55 13.23 12.25
September 8.71 8.85 8.88 9.20 8.47 8.82
October 8.00 7.23 7.19 6.81 6.53 7.15
November 7.18 7.06 6.71 6.45 5.97 6.67
December 7.27 7.12 8.58 8.52 8.54 8.01
Alex was the able to estimate sales for January 2011 in the following manner:Because Alex was using spreadsheet software, the monthly averages were computed out to more than two decimal places. This explains why the calculations are not exact. As in the case of January, the actual monthly percentage was closer to 6.3821 percent, which provides the monthly forecast of \$26,737.
January 2011 sales = annual sales 2011 × January percentage = (\$418,937) × (6.38 percent) = \$26,737.
Using the same approach, he was able to compute forecasted sales for February and March. To maintain sales, Alex offers his customers a rather generous credit policy. He asks them to pay 50 percent of the bill in the month in which the work is done; another 35 percent of the bill in the following month, and the remaining 15 percent of the bill two months after the work has been completed. For Alex to project cash inflows for January, he would need to consider sales from the two prior months—December and November. His projected cash inflows for January would be determined as follows:These calculations have been rounded to the nearest dollar. This is also true for the values in Table 10.6 “Cash-Flow Projections for the First Quarter of 2011”.
November 2010 sales = \$23,466
December 2010 sales = \$33,583
January 2011 sales = \$26,737
cash inflow from November 2010 sales = (\$23,466) × 15 percent = \$3,520
cash inflow from December 2010 sales = (\$33,583) × 35 percent = \$11,754
cash inflow from January 2011 sales = (\$26,737) × 50 percent = \$13,368
total cash inflows from operations = sum of cash inflows for three months = \$28,642.
Alex then estimates his cash outflows from operations. From past experience, he knows that the purchases of parts and materials run approximately 50 percent of the dollar value of his sales. However, because of delays in acquiring parts and materials, he must order them in advance. He has to anticipate what sales would be the following month and has to place a purchase order predicated on that value. Further, 60 percent of that dollar value is in that month and the remaining 40 percent is in the following month. This can be illustrated for January 2011. To determine the purchases of parts and materials in January, he begins with his forecast for sales in February 2011.
February 2011 sales = \$25,637
parts and materials purchases in January 2011 = 50 percent of February 2011 sales = 50 percent × \$25,637 = \$12,819.
He is obligated to pay 60 percent of this amount in January 2011 and the remaining 40 percent in February 2011. This also means that his cash outlay in January 2011 must include a payment for 40 percent of December’s purchases.
parts and materials purchases in December 2011 = 50 percent of January 2011 sales = 50 percent × \$26,737 = \$13,369
parts and materials cash outlay in January 2011 = 60 percent of purchases January 2011 + 40 percent of purchases December 2010
parts and materials cash outlay in January 2011 = (60 percent × \$12,819) + (40 percent × \$13,369) = \$13,038.
In addition to purchasing parts and materials, Alex has to consider his operational expenses, which include wages, payroll taxes, office supplies, repairs, advertising, and expenses related to automobiles, phone bills, rent, utilities, expenses associated with accounting services, and taxes. These are itemized in Table 10.6 “Cash-Flow Projections for the First Quarter of 2011”. Adding in these expenses brings his total cash outflow \$19,864.
For January 2001, he has no cash inflows or cash outflows with respect to either investment activities or financing activities. This means that his total cash flow for January 2011 represents the difference between cash inflows and outflows for operational activities. His cash flow for January 2011 was a positive value of \$8,778. Because he ended December 2010 with a cash position of \$3,177, the addition of this \$8,778 brings his cash position at the end of January 2011 to \$11,955. His bank, with which he has an open line of credit, requires that he maintain a minimum of \$2,500 in his cash account each month. Should Alex drop below this amount, his bank will lend him—automatically—up to \$5,000.
It is useful to examine the rest of his projections (see Table 10.6 “Cash-Flow Projections for the First Quarter of 2011”). February 2011 follows much as January 2011. Alex was able to produce a positive net cash flow in February of \$5,669, which brought his ending cash position at the end of February 2011 to \$17,624.
Unlike the other months of 2011, Alex planned on producing cash flows with respect to investment activities in March 2011. He planned on selling an asset to a friend and anticipated a positive cash flow of \$500 from this sale. He also planned on purchasing a used van in March 2011 and estimated that the price would be \$21,000. His intention was to pay for the van from his cash account and not take out a car loan. His cash outflows for March 2011 were a negative \$16,075. With the bank’s requirement of maintaining a \$2,500 minimum balance, this meant that Alex activated the automatic borrowing option from his bank to the amount of \$950. It required some effort on Alex’s part to build the cash-flow spreadsheet, but it enabled him to examine various options, such as the impact of deferring the purchase of the van until May 2011. Although any cash-flow spreadsheet is dependent on the accuracy of forecasts, it is a mechanism by which a small business owner can examine various scenarios and determine the possible impact of those scenarios on his or her overall cash flow.
Table 10.6 Cash-Flow Projections for the First Quarter of 2011
November December January February March
Cash Flow from Operating Activities
Cash on hand at end of month \$3,177 \$11,955 \$17,624 \$1,550
Cash Inflow from Operations
Sales \$23,466 \$33,583 \$26,737 \$25,637 \$31,537
Cash flow from month of sales \$13,369 \$12,818 \$15,769
Cash flow from prior month’s sales \$11,754 \$9,358 \$8,973
Cash flow from two month’s prior sales \$3,520 \$5,037 \$4,011
Total cash inflow from operations \$28,642 \$27,214 \$28,752
Parts Purchases
Cash outflow for this month’s purchases \$7,691 \$9,461 \$9,533
Cash outflow for prior month’s purchases \$5,347 \$5,127 \$6,307
Gross wages (excludes withdrawals) \$4,000 \$4,000 \$4,000
Payroll expenses (taxes, etc.) \$150 \$150 \$150
Outside services \$— \$— \$—
Supplies (office and operating) \$50 \$50 \$50
Repairs and maintenance \$— \$— \$450
Advertising \$100 \$200 \$250
Auto, delivery, and travel \$120 \$150 \$180
Accounting and legal \$200 \$200 \$200
Rent \$1,650 \$1,650 \$1,650
Telephone \$65 \$65 \$65
Utilities \$325 \$325 \$325
Insurance \$166 \$166 \$166
Taxes (real estate, etc.) \$— \$— \$1,000
Interest \$—
Other expenses \$— \$— \$—
Total cash outflows from operations \$19,864 \$21,544 \$24,327
Sale of asset \$— \$— \$500
Sale of debt or equity \$— \$— \$—
Collection of principal on a loan \$— \$— \$—
Total cash flow from investing activities \$— \$— \$500
Purchase of plant, property, and equipment \$— \$— \$21,000
Purchase of debt \$— \$— \$—
Total cash outflows from investing \$— \$— \$21,000
Sales of securities or equity \$— \$— \$—
Issue of debt instruments \$— \$— \$—
Total cash inflow from financing activities \$— \$— \$—
Payment of dividends \$— \$— \$—
Redemption of long-term debt \$— \$— \$—
Total cash outflows from financing \$— \$— \$—
Net cash flow \$8,778 \$5,669 \$(16,075)
Required cash balance \$2,500 \$2,500 \$2,500 \$2,500 \$2,500
Required borrowing \$— \$— \$(950)
Video Clip 10.11- Cash-Flow Analysis
A discussion of cash flow.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Key Takeaways
• To truly understand how well a business is doing requires an ability to understand the financial statements of the business.
• The balance sheet shows what a business owns and what claims are on the business.
• The income statement shows how profitable a business is and identifies the expenses of the business.
• Cash flow is the lifeblood of a business’s operation.
• Cash-flow projections are vital for any business.
Exercises
Edwina Haskell was an accomplished high school student who looked forward to attending Southern New England University (SNEU). SNEU was unique in that it operated on a trimester basis, its policy was to actively foster independent development among the students. Edwina’s mother and father each own their own small businesses. Soon after freshman orientation at SNEU, Edwina recognized a need among the students that could be the basis for developing a small business. Freshman students could not bring their cars on the campus. In effect, they were confined to the dorm; if they wished to travel, they had to take school-provided buses that operated on a fixed schedule. Further, the university’s cafeteria closed at eight in the evening. Students who wanted to have some food or snacks after 8:00 p.m. had to call local restaurants that delivered. The few restaurants in the neighborhood around SNEU that had delivery services often were late in their deliveries, and hot food, such as pizza, was frequently delivered cold.
Edwina felt that there was a niche market on the campus. She believed that students would be interested in ordering sandwiches, snacks, and sodas from a fellow student provided that the food could be delivered in a timely fashion. After talking with several students in her dorm complex, she believed that offering a package of a sandwich, a soda, and a small snack, such as potato chips, for \$5 and a guaranteed delivery of 15 minutes or less would be a winner. Because her dorm complex consisted of four large adjoining buildings that house nearly 1,600 students, she felt that there would be sufficient demand to make the concept profitable. She talked about this concept with her roommates and with her parents. Her roommates were willing to help prepare the sandwiches and deliver them. She planned on paying each of them \$250 per trimester for taking orders, making sandwiches, and delivering them. All three roommates, whom she knew from high school, were willing to be paid at the end of the trimester.
Edwina recognized that for this business plan to work, she would have to have a sufficient inventory of cold cuts, lettuce, tomatoes, soda, chips, and condiments to be able to meet student demands. The small refrigerators in the dorm rooms would not be sufficient. After talking to her parents, they were willing to help her set up her business. They would lend her \$1,000 to buy a larger refrigerator to place in her dorm room. She did not have to repay this loan until she graduated in four years, but her parents wanted her to appreciate the challenges of operating a small business. They set up several conditions. First, although she did not have to pay back the \$1,000 for the refrigerator for four years, she had to pay interest on this “loan.” She had to repay 3 percent of this loan each trimester. Further, they reminded her that although she could pay her friends at the end of the semester, she would need funds to buy the cold cuts, bread, rolls, soda, snacks, condiments, and supplies such as foil to wrap the sandwiches, plus plates and paper bags. Although Edwina was putting \$500 of her own money into her business, her parents felt that she might need an infusion of cash during the first year (i.e., the first three trimesters). They were willing to operate as her bank—lending her money, if needed, during the trimesters. However, she had to pay the loan(s) back by the end of the year. They also agreed that the loan(s) would be at a rate of 2 percent per trimester.
Within the first three weeks of her first trimester at SNEU, Edwina purchased the \$1,000 refrigerator with the money provided by her parents and installed it in her dorm. She also went out and purchased \$180 worth of supplies consisting of paper bags; paper plates; and plastic knives, spoons, and forks. She paid for these supplies out of her original \$500 personal investment. She and her roommates would go out once or twice a week, using the SNEU bus system to buy what they thought would be the required amount of cold cuts, bread, rolls, and condiments. The first few weeks’ worth of supplies were purchased out of the remainder of the \$500. Students paid in cash for the sandwiches. After the first two weeks, Edwina would pay for the food supplies out of the cash from sales.
In the first trimester, Edwina and her roommates sold 640 sandwich packages, generating revenue of \$3,200. During this first trimester, she purchased \$1,710 worth of food supplies. She used \$1,660 to make the 640 sandwich packages. Fortunately, the \$50 of supplies were condiments and therefore would last during the two-week break between the trimesters. Only \$80 worth of the paper products were used for the 640 sandwich packages. Edwina spent \$75 putting up posters and flyers around the campus promoting her new business. She anticipated that the tax rate would be approximately 35 percent of her earnings before taxes. She estimated this number at the end of the first trimester and put that money away so as to be able to pay her tax bill.
During the two weeks off between the first and second trimester, Edwina and her roommates talked about how they could improve business operations. Several students had asked about the possibility of having warm sandwiches. Edwina decided that she would purchase two Panini makers. So at the beginning of the second trimester, she tapped into her parents’ line of credit for two Panini grills, which in total cost \$150. To make sure that the sandwiches would be delivered warm, she and her roommates spent \$100 on insulated wrappings. The \$100 came from cash. The second trimester proved to be even more successful. The business sold 808 sandwiches, generating revenue of \$4,040. During this second trimester, the business purchased \$2,100 worth of food supplies, using \$2,020 of that to actually create the 808 sandwich packages. They estimated that during the second trimester, they used \$101 worth of supplies in creating the sandwich packages.
There was only a one-week break between the second and third trimesters, and the young women were quite busy in developing ideas on how to further expand the business. One of the first decisions was to raise the semester salary of each roommate to \$300 apiece. More and more students had been asking for a greater selection of warm sandwiches. Edwina and her roommates decided to do some cooking in the dorms so as to be able to provide meatball and sausage sandwiches. Edwina once again tapped into her parents’ line of credit to purchase \$275 worth of cooking supplies. One of the problems they noticed was that sometimes students would place calls to order a sandwich package, but the phones were busy. Edwina hired a fellow student to develop a website where students could place an order and select the time that they would like a sandwich package to be delivered. The cost of creating and operating this website for this third trimester was \$300.
This last semester of Edwina’s freshman year proved to be the most successful in terms of sales. They were able to fulfill orders for 1,105 sandwich packages, generating revenue of \$5,525. Edwina determined that the direct cost of food for these sandwich packages came out to be \$2,928.25. The direct cost of paper supplies was \$165.75. At the end of her freshman year, Edwina repaid her parents the \$425 that came from her credit line that was used to purchase the Panini makers and the cooking utensils.
1. Prepare a beginning balance sheet for the first day of Edwina’s business.
2. Prepare income statements for the end of each trimester.
3. Prepare balance sheets for the end of each semester.
Financial Ratio Analysis
Learning Objectives
1. Understand why the numbers found on a balance sheet and an income statement may not be enough to properly evaluate the performance of a business.
2. Understand the concept of financial ratios and the different categories of financial ratios.
3. Acquire the ability to calculate financial ratios and interpret their meaning.
One can say that figures lie. But figures, when used in financial arguments, seem to have the bad habit of expressing a small part of the truth forcibly, and neglecting the other, as do some people we know.[20]
Fred Schwed
Section 10.1 “Understanding the Need for Accounting Systems” discusses the differences between managerial accounting and financial accounting. Managerial accounting focuses on providing information that is useful for the managers of a firm. Financial accounting provides information to interested external constituencies. Both use information derived from financial statements. These numbers, however, may not provide a singular insight into the overall economic effectiveness of any particular business. These numbers must be placed in some form of context. As an example, suppose you are told that a particular business earned \$2 million worth of profit last year. Obviously, earning a \$2 million profit is better than a \$1 million profit and certainly better than a \$2 million loss. However, you are still left with the question of exactly how good that \$2 million profit is. After all, if you were told that Walmart made only \$2 million profit last year, you would likely be concerned with respect to the management capability and performance of Walmart. Making only \$2 million profit on revenues in excess of \$400 billion worth of sales would not be at all impressive. However, if you were told that a mom-and-pop grocery store made \$2 million profit last year based on \$4 million of sales, you would be amazed at that mom-and-pop store and hold them in considerable esteem for their management capability.
One way of putting financial data into a comparative context is known as financial ratio analysis. From a financial accounting standpoint, ratio analysis enables external constituencies to evaluate the performance of a firm with respect to other firms in that particular industry. This is sometimes referred to as comparative ratio analysis. From a managerial accounting standpoint, ratio analysis can assist a management team to identify areas that might be of concern. The management team can track the performance on these ratios across time to determine whether the indicators are improving or declining. This is referred to as trend ratio analysis. There are literally scores of financial ratios that can be calculated to evaluate a firm’s performance.
Financial ratios can be grouped into five categories: liquidity ratios ;financial leverage ratios ;profitability ratios ;asset management or efficiency ratios ; and market value ratios. Because many small businesses are not publicly held and have no publicly traded stock, market ratios play no role in analyzing a small firm’s performance. This section will review some of the most commonly used ratios in each category.
Liquidity ratios provide insight into a firm’s ability to meet its short-term debt obligations. It draws information from a business’s current assets and current liabilities that are found on the balance sheet. The most commonly used liquidity ratio is the current ratio given by the formula:
current assets / current liabilities.
The normal rule of thumb is that the current ratio should be greater than one if a firm is to remain solvent. The greater this ratio is above one, the greater its ability to meet short-term obligations. As with all ratios, any value needs to be placed in context. This is often done by looking at standard ratio values for the same industry. These ratios are provided by Dun and Bradstreet; these data are also available on websites, such as Bizstats.com.
Another ratio used to evaluate a business’s ability to meet in short-term debt obligations is the quick ratio—also known as the acid test. It is a more stringent version of the current ratio that recognizes that inventory is the least liquid of all current assets. A firm might find it impossible to immediately transfer the dollar value of inventory into cash to meet short-term obligations. Thus the quick ratio, in effect, values the inventory dollar value at zero. The quick ratio is given by the following formula:
current assets − inventory / current liabilities.
Using the data provided in the balance sheet for Acme Enterprises (Table 10.2 “Acme Enterprises’ Balance Sheet, 2005–2010 (\$ Thousands)”), we can compute the current ratio and the quick ratio. The results for Acme Enterprises and its industry’s means are provided in Table 10.7 “Liquidity Ratio Results”.
Table 10.7 Liquidity Ratio Results
2005 (%) 2006 (%) 2007 (%) 2008 (%) 2009(%) 2010 (%)
Acme’s current ratio 0.83 0.79 0.75 0.70 0.65 0.60
Industry’s current ratio 1.15 1.08 1.04 1.02 1.03 1.01
Acme’s quick ratio 0.63 0.60 0.57 0.53 0.49 0.45
Industry’s quick ratio 1.04 1.02 0.98 0.95 0.94 0.91
One should immediately notice that this business appears to be in serious trouble. None of the current ratios are above of value of 1.0, which indicates that the business would be unable to meet short-term obligations to its creditors should they have to be paid. Acme’s current ratios are below the industry’s average values; however, it should be noted that the industry’s values are quite close to one. Further, the current ratio values for Acme and the industry are declining, but Acme’s are declining quite significantly. This indicates the financially precarious position of the firm is growing steadily worse. The quick ratio shows an even direr situation should the firm not be able to sell off its inventory at market value. Acme’s quick ratio values are well below the industry’s average. Without these two ratios, a quick perusal of the total current assets of Acme Enterprises would result in a false impression that the firm is growing in a healthy fashion and current assets are rising.
Financial leverage ratios provide information on a firm’s ability to meet its total and long-term debt obligations. It draws on information from both the balance sheet and the income statement. The first of these ratios—the debt ratio—illustrates the extent to which a business’s assets are financed with debt. The formula for the debt ratio is as follows:
total debt / total assets.
A variation on the debt ratio is the ratio of debt to the total owner’s equity (the debt-to-equity ratio). As with the other ratios, one cannot target a specific, desirable value for the debt-to-equity ratio. Median values will vary significantly across different industries. The automobile industry, which is rather capital intensive, has debt-to-equity ratios above two. Other industries, such as personal computers, may have debt-to-equity ratios under 0.5.[21] The formula for the debt-to-equity ratio is as follows:
total debt / total owner’s equity.
One can refine this ratio by examining only the long-term portion of total debt to the owner’s equity. Comparing these two debt-to-equity ratios gives insight into the extent to which a firm is using long-term debt versus short-term debt. The formula for the long-term debt-to-owner’s equity ratio is as follows:
long-term debt / total owner’s equity.
The interest coverage ratio examines the ability of a firm to cover or meet the interest payments that are due in a designated period. The formula for the interest coverage ratio is as follows:
EBIT / total interest charges.
The financial leverage ratios for Acme and its industry are provided in Table 10.8 “Financial Leverage Ratios Results”. Interestingly, Acme’s debt-to-total-assets ratio has declined over the last six years. Further, its ratio has always been lower than the industry average in every year. This stands in contrast to the liquidity ratios. The business’s debt-to-equity ratio has declined precipitously over the last six years and was significantly lower than the industry averages. The same is true for the long-term debt-to-equity ratios. These ratios have declined for several reasons. The total assets of the firm have doubled over the last six years, and equity has grown by a factor of five while the long-term debt has remained constant. It would appear that the firm has been financing its growth with short-term debt and its own profits. However, one should note that the times interest earned ratio has declined dramatically, falling to approximately half the level of the industry average in 2010. This indicates that the firm has less ability to meet its debt obligations. In conjunction with the results of the other ratios, one would say that Acme has relied, excessively, on its short-term debt and should take actions to return to a firmer financial footing.
Table 10.8 Financial Leverage Ratios Results
2005 (%) 2006 (%) 2007 (%) 2008 (%) 2009 (%) 2010 (%)
Acme’s debt-to-total assets ratio 0.86 0.78 0.73 0.69 0.67 0.65
Industry’s debt-to-total assets ratio 1.01 0.97 0.95 0.92 0.89 0.86
Acme’s debt-to-equity ratio 6.14 3.57 2.68 2.22 1.99 1.86
Industry’s debt-to-equity ratio 3.31 3.25 3.67 3.11 2.96 2.65
Acme’s long-term debt-to-equity ratio 1.88 1.02 0.70 0.53 0.43 0.36
Industry’s long-term debt-to-equity ratio 1.52 1.54 1.42 1.32 1.27 1.12
Acme’s times interest earned ratio 14.76 12.34 10.68 8.52 7.17 5.52
Industry’s times interest earned ratio 11.55 11.61 10.95 10.65 10.43 10.01
The next grouping of ratios is the profitability ratios. Essentially, these ratios look at the amount of profit that is being generated by each dollar of sales (revenue). Remember, from the review of the income statement, we can identify three different measures of profit: gross profit, operating profit, and net profit. Each measure of profit can be examined with respect to the net sales of a business, and each can give us a different insight into the overall efficiency of a firm in generating profit.
The first profitability ratio examines how much gross profit is generated by each dollar of revenue and is given by the following formula:
gross profit margin = gross profit / revenue.
The next examines operating profit per dollar of sales and is calculated in the following manner:
operating profit margin = operating profit / revenue.
Lastly, the net profit margin is the one that is mostly used to evaluate the overall profitability of a business. It is determined as follows:
net profit margin = net profit / revenue.
The profitability ratios for Acme and its industry are provided in Table 10.9 “Profitability Ratios Results”. Acme has seen a slight increase in its gross profit margin over the last six years, which indicates a reduction in either direct labor or direct materials costs. Acme’s gross profit margin is slightly lower, across the six years, than the industry’s mean values. Acme’s operating profit margins have declined, particularly since 2008. This would indicate, in light of an increasing gross profit margin, that its operating expenses have increased proportionately. Acme’s operating profit margins had parity with its industry until 2008. The most troublesome results may be the net profit margins, which experienced a one-third decline over the last six years. Although the industry’s net profit margins have declined, they have not done so at the same rate as those for Acme. These results indicate that Acme needs to carefully review its operational expenses with a clear intention to reduce them.
Table 10.9 Profitability Ratios Results
2005 (%) 2006 (%) 2007 (%) 2008 (%) 2009 (%) 2010 (%)
Acme’s gross profit margin 50.0 50.0 51.0 51.0 52.0 52.0
Industry’s gross profit margin 51.2 51.3 51.6 51.5 53.2 53.1
Acme’s operating profit margin 15.5 14.3 14.0 12.7 12.3 10.9
Industry’s operating profit margin 14.7 14.1 14.2 13.2 13.0 13.2
Acme’s net profit margin 9.5 8.7 8.4 7.4 7.0 6.0
Industry’s net profit margin 9.2 8.9 8.5 8.4 8.1 7.9
The last category of financial ratios is the asset management or efficiency ratios. These ratios are designed to show how well a business is using its assets. These ratios are extremely important for management to determine its own efficiency. There are many different activity or efficiency ratios. Here we will examine just a few. The sales-to-inventory ratio computes the number of dollars of sales generated by each dollar of inventory. Firms that are able to generate greater sales volume for a given level of inventory are perceived as being more efficient. This ratio is determined as follows:
sales to inventory = sales / inventory.
There are other efficiency ratios that look at how well a business is managing its inventory. Some look at the number of days of inventory on hand; others look at the number of times inventory is turned over during the year. Both can be used to measure the overall efficiency of the inventory policy of a firm. For simplicity’s sake, these ratios will not be reviewed in this text.
The sales-to-fixed-asset ratio is another efficiency measure that looks at the number of dollars of sales generated by a business’s fixed assets. Again, one is looking for a larger value than the industry average because this would indicate that a business is more efficient in using its fixed assets. This ratio is determined as follows:
sales to fixed assets = sales / fixed assets.
Another commonly used efficiency ratio is the days-in-receivables ratio. This ratio shows the average number of days it takes to collect accounts receivables. The desired trend for this ratio is a reduction, indicating that a firm is being paid more quickly by its customers. This ratio is determined as follows:
days in receivables = accounts receivable / (sales / 365).
The 365 in the denominator represents the number of days in a year. A summary of the activity ratios for Acme and the industry is provided in Table 10.10 “Efficiency Ratios Results”.
Table 10.10 Efficiency Ratios Results
2005 (%) 2006 (%) 2007 (%) 2008 (%) 2009 (%) 2010 (%)
Acme’s sales to inventory 14.3 14.3 14.3 14.3 14.3 14.3
Industry’s sales to inventory 16.2 15.7 15.3 14.9 14.3 13.7
Acme’s sales to fixed assets 8.57 7.02 6.01 5.28 4.75 4.33
Industry’s sales to fixed assets 7.64 7.12 6.78 6.55 6.71 6.34
Acme’s days in receivables 36.5 36.5 36.5 36.5 36.5 36.5
Industry’s days in receivables 33.2 34.6 38.2 37.4 33.9 35.1
Almost immediately one should notice several interesting sets of value. Acme’s sales-to-inventory ratios for the period 2005 to 2010 and its days in receivables for the same time frame are constant. This is not true for the industry values. This might indicate that Acme has a rigorous policy of tying its inventory level to sales. Likewise, it would appear that Acme has some formal policy to explicitly link accounts receivable to sales volume. Industry values for both ratios fluctuated across the time span; however, it should be noted that the industry’s days in receivables fluctuated across a rather narrow band. Acme’s sales to fixed assets have been declining from 2005 to 2010. In fact, it has dropped almost in half. This is a sign that Acme’s ability to manage its assets vis-à-vis sales has declined significantly and should be a source of considerable worry for the management team.
Financial ratios serve an extremely useful purpose for small business owners who are attempting to identify trends in their own operations and see how well their business’s stand up against its competitors. As such, owners should periodically review their financial ratios to get a better understanding of the current position of their firms.
Video Clip 10.12 Financial Ratios: Debt Management
Basic coverage for calculating debt ratios.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.13 Financial Ratios: Profitability
Basic coverage for calculating profitability ratios.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Video Clip 10.14 Financial Ratios: Asset Management
Basic coverage for calculating asset management ratios.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=108
Key Takeaways
• Financial ratios enable external constituencies to evaluate the performance of a firm with respect to other firms in a particular industry.
• Ratio analysis can help a management team identify areas that might be of concern.
• The management team can track the performance on these ratios across time to determine whether the indicators are improving or declining.
• Financial ratios can be grouped into five categories: liquidity ratios, financial leverage ratios, asset management or efficiency ratios, profitability ratios, and market value ratios.
The Three Threads
Learning Objectives
1. To understand that a functioning accounting system can provide customer value through accurate billings and records.
2. To understand that there are several techniques that can help a small business maintain a positive cash flow.
3. To appreciate that small businesses can use sophisticated, low-cost computer accounting systems to manage their accounting and operational operations.
Customer Value
One might find at first consideration a tenuous link between a business’s accounting system and the concept of customer value. However, if looked at from the customer’s perspective, a business that provides accurate and prompt billings is a business that can control its costs, which can result in lower prices. A business that improves its overall efficiency because it can accurately monitor and track its operations provides far greater value than a business with a haphazard approach to accounting controls.
The ability to tailor a business’s operations to better meet customer needs is the key to providing value. As a business acquires a better appreciation of its capabilities, it can then make improvements that will better meet customer needs and outperform competitors.[22]
As a business grows more confident in its ability to handle accounting issues, it may wish to look at more sophisticated techniques that can better serve the business and the customer. As Andrew Hereth puts it, “An accounting process needs to be established that accounts for the cost of each customer, for each market and for each channel.[23]
Cash-Flow Implications
Like good health, positive cash flow is something you’re most aware of when you haven’t got it. That’s one of the most profound truths in life.[24]
Robert Heller
Creating a positive cash flow or at least reducing a negative cash flow should be of central interest to all small businesses. Unlike the example of Alex’s Soft Serve Services, not all small businesses can anticipate that they will be able to cover a negative cash flow simply by borrowing. That means that businesses must be much more proactive in attempting to eliminate or reduce negative cash flows. Therefore it is important to examine some ways in which a small business can increase its cash inflows.
• Restrict credit and credit terms. Many small businesses, but not all, offer credit terms and policies for current and potential customers. The easier the credit, the more likely a business will be able to generate a sale; however, easy credit terms generally mean that it will take a longer period of time for the business to receive the total cash payment from a sale. Thus many businesses accept only cash or debit and credit cards. Restricting the credit terms may simply mean that credit is provided only to particular customers or the terms of the credit are tightened—for example, 60 percent of the sale price is due the day of the sale, and the remaining 40 percent would be due in thirty days.
• Conduct credit checks. Businesses that plan to offer credit to customers, particularly customers who will be making large purchases, may find that it pays to spend money to conduct a credit check on these customers. Again, the use of credit checks is very much a function of the type and size of the business and the potential sales that may be involved.
• Make credit terms explicit. For businesses that provide credit to their customers, it is critical to make sure the customer has an explicit idea of what the exact credit terms are. In the long run, it will pay to clearly indicate on the invoice the exact payment schedule.
• Provide incentives to expedite customer payment. It is often worth to knock off several percentage points on a sale to speed up a customer’s payment. The exact size of the discount will have to be determined by the business owner.
• Request partial payment in advance. When providing credit terms, small businesses should consider the requirement of a deposit or a retainer up front. Hopefully, this should not deter many customers from purchasing particularly high-priced items. The request for payment in advance assures that a business will receive some cash inflow even if the customer defaults.
One of the best ways to maintain a positive cash flow is to reduce the size of the negative cash flow, which can be done by conducting cash-flow analyses on a regular basis. Throughout this chapter, the time frame most commonly used has been the fiscal year or a fiscal month. In the case of rigorously monitoring cash flow, it is strongly suggested that one consider using even smaller time units, namely a weekly analysis or even a daily analysis.
Digital Technology and E-Environment Implications
Computer-based accounting systems have much to offer the owner of a small business. Most small businesses would find that a computerized accounting system has the following advantages over a manual system:
• Accuracy. In computerized systems, data entry can be structured so as to preclude the input of wrong information. Further, transactions are entered only once in computerized systems, whereas they may require several entries in a manual system.
• Speed. Data entry and data retrieval can occur on a real-time basis. Calculations are done instantly in a computerized system. For businesses with multiple locations, data can be instantly coordinated rather than waiting for the collection of data from diverse locations as would occur with manual systems.
• Report generation. Computerized systems can provide real-time generation of a variety of reports that can enable owners or operators to improve their decision making.
• Cost reduction. Although small businesses may be required to expend money on the initial purchase (and maintenance) of computerized accounting system, these systems often provide significant savings in terms of reducing the amount of time required for bookkeepers and accountants to track businesses records.[25]
• Backup. The records in a computerized system can be backed up at a variety of locations. This minimizes the chance that all records would be destroyed in some form of accident, such as a fire or a flood, as might be the case with paper records in a manual system.[26]
Computer-based accounting packages that have been designed for small to midsize businesses have been available for more than a quarter of a century. Many of the packages that existed twenty-five years ago are no longer available. Some have argued that a natural selection process exists for computerized accounting system so that today’s survivors represent the best qualities required of such systems.[27] In recent years, a whole new category of accounting software has been developed—cloud-based software. This software resides on the web and does not require a software package to be downloaded on small business owner’s computer. Such programs are accessible from any computer.
Selecting a new computer accounting system or changing from a manual system to a computer-based system is a major step for any small business. It should be conducted with careful consideration and treated as a major project. Prior to starting the project, it is highly advisable to sit down with one’s accountant and consider the options. Some of the first steps in starting this project involve specifying the budget and the required attributes of the software package. In developing the budget, one should consider the initial acquisition price of the software, training costs, and maintenance costs. If one is planning to move from one computerized accounting system to another, the cost of transferring operations should also be considered in the overall budgeting process. With regard to the initial purchase price, these packages can range from being free to costing thousands of dollars depending on the number of modules required. Some systems use a fee structure that is based on the number of users. This would allow a business owner to get some sense of the look and the feel of the software package.
The second initial phase of the acquisition process centers on identifying what is needed in the accounting package. This relates to the elements (support services) or modules that are absolutely required. One should also identify what modules might be of benefit at some point in the future. To assist an owner in identifying what modules are required or may be required in the future, the information that flows into the accounting system must be specified. In Section 10.1 “Understanding the Need for Accounting Systems”, we refer to the idea of accounting transactions, which fall into several categories. A business needs to identify all the required categories, particularly if it is transitioning from a manual system to a computerized system. A business also needs to identify the accounting reports that are required throughout the business. It is important to consider if the software is compatible with e-business, e-commerce, and Internet capabilities.
Another issue is to consider how many people will have to access the system throughout the entire business. This number will have a dramatic impact on the training requirements. Recognize that the business will have to provide manuals that must be accessible to all who will be using the accounting system. This also brings up the issue of the necessity of employee training programs. Consider the relative ease of use of any computerized accounting system—not only for yourself but also for the employees. This is where an understanding of the learning curve of using the system will be extremely important. Again, a business’s accountant can play a critical role not only in determining the selection of the system but also in developing training programs for the employees and showing them how to use the system. Having generated this list of the required components of the accounting system, one should identify competing software products (along with their costs) and prioritize them, as shown in Figure 10.6 “Evaluation of Computer Accounting Systems”. In addition to consulting with an accountant, a business owner should review the various accounting software packages by talking to other business owners, reading evaluations in the business and computer press, and exploring software packages on a trial basis.[28] Many accounting software packages allow users to try out the system with no initial charge. After a fixed period of time, usually thirty days, the program becomes inoperative. This allows you to become familiar with the look and the feel of the software.
Figure 10.6 Evaluation of Computer Accounting Systems
The third preliminary step is the creation of a timeline that would determine when you must successfully implement the accounting package into the actual operations of the business. This timeline should consider the time required to conduct test runs of the software. Tests should be conducted with only one or two modules. They should be operated for a sufficient period of time (at least a month) to examine if the system works as well as the manual system or the current computerized system. A timeline should also be created for training the personnel who will be using the software.
Moving to a computerized accounting system or a new system means that you should be ready for any disaster. To prepare for such disasters, there should be a formal policy of backing up all data on a regular basis. The backed up data should be at another locale other than the main storage site. Portable hard drives for off-site data storage site serve this purpose well. Some software packages perform their own backup procedures.
Several factors may need to be considered when examining accounting software for small businesses, including the following: will the software run on computers that a business currently uses, how often should the company provide updates of the software, and are there specific versions of the accounting software for the industry in which a business operates. Small businesses should also consider cloud computing options with regard to accounting software. Cloud computing refers to the fact that programs and data are stored off-site at another location. This means that accounting transactions can be entered from any computer, in some cases from smartphones, and are accessible anywhere in the world. Although for start-up businesses and the very smallest of businesses the adoption of a computerized accounting system appears to be a daunting task, in the long run, it is a key element for the long-term survival of the business.
Video Link 10.1- Evaluating Accounting Software
Video that discusses ways to determine what software is best.
www.ehow.com/video_5103398_evaluating-accounting-software.html
Key Takeaways
• Good accounting systems can help a firm provide value to its customers through better billing and increased efficiency.
• Small businesses can be proactive in preserving cash flow through a variety of simple actions.
• Small businesses today can acquire very powerful computer accounting software packages. These packages are affordable and relatively easy to use.
Exercises
1. Besides the suggestions provided, what other approaches might a small business use to preserve cash flow?
2. Select five or six computerized accounting packages (including one of the cloud variety) that might be used by a start-up restaurant, and prepare a rigorous analysis of which should be selected and why.
Disaster Watch
Sales and cash-flow forecasting can often prove to be a significant challenge to small business owners. Assumptions have to be made, forecasting models must be selected, and calculations have to be made. In many cases, the forecasts will not be exact. This can be profoundly frustrating. Yet one of the great benefits of forecasting is that it may force a small business owner to think about what the future may hold. However, neither small businesses nor large businesses can predict or plan for all events. Certain events just happen. Given this element of unpredictable chance, businesses should think about how they might protect and conserve their cash flow should the “unthinkable” occur.
Yankee Gas had a project that involved installing a pipeline from Waterbury, Connecticut, to Wallingford, Connecticut.[29] The original intent according to Yankee Gas was that all work on the pipeline would occur during the night to minimize customer disruptions. Or at least, this was what the storeowners along the line of the work were told. During one phase of the project, the company altered the schedule and began working during daytime hours. Installation involved digging a trench into which the pipeline was laid. This produced a major disruption that required that traffic be diverted away from several businesses’ main entrances and their parking lots. Multiple businesses found their customers had to be “forceful” with the local police to enter areas near the businesses. One of the businesses was a deli that focused on preparing fresh food on a daily basis. Food that was not sold during the day had to be discarded that night. This occurred during the summer months, which were the best times for this deli. A local gas station saw sales drop so precipitously that the owner was unable to meet the rent.
One of the responses on the part of many of the business owners was to seek compensation. Unfortunately, they found that no one was willing to accept responsibility for the detour policy. As an owner of a travel agency put it, “The Town said it was the State, the State said it was the (local) police and the police said it was Yankee Gas.”[30]. While the owners await the resolution of responsibility, they have to consider the possibility of more street work during the following summer.
1. Independent (London), April 21, 2010, quoted in “Accounting Quotes,” Qfinance, accessed February 14, 2012, http://www.qfinance.com/finance-and-business-quotes/accounting.
2. Ramnik Singh Wahla, Accounting Terminology Bulletin No. 1: Review and Résumé, 1953, accessed February 14, 2012, c0403731.cdn.cloudfiles.rackspacecloud.com/collection/papers/1950/1953_0101_AccountingReview.pdf.
3. Denise Schmandt-Besseart, “An Ancient Token System: The Precursor to Numerals and Writing,” Archaeology 39 (1986): 32–39
4. Richard Mattessich, “Prehistoric Accounting and the Problem of Representation: On Recent Archeological Evidence of Middle East from 8000 B.C. to 3000 B.C.,” Accounting Historians Journal 14, no. 2 (1987): 71–91
5. Salvador Carmona and Mahmoud Ezzamel, “Accounting and Forms of Accountability in Major Civilizations: Mesopotamia and Ancient Egypt” (working paper, Instituto de Empresa Business School, Madrid, Spain, and Cardiff University, Cardiff, UK, 2005), accessed December 2, 2011, latienda.ie.edu/working_papers_economia/WP05-21.pdf.
6. John R. Alexander, History of Accounting (Princeville, HI: Association of Chartered Accountants in the United States, 2002), 4
7. John R. Alexander, History of Accounting (Princeville, HI: Association of Chartered Accountants in the United States, 2002), 9.
8. Jean Murray, “Finding Help with Bookkeeping and Accounting Tasks,” About.com, accessed December 2, 2011, biztaxlaw.about.com/od/businessaccountingrecords/a/findacpa.htm.
9. “Edwin T. Freedley,” Cyber Nation, accessed February 14, 2012, http://www.cybernation.com/victory/quotations/authors/quotes_freedley_edwint.html.
10. “Comparison of Cash and Accrual Methods of Accounting,” Wikipedia, accessed December 2, 2011, en.Wikipedia.org/wiki/comparison_of_cash_method _and_accrual method of accounting.
11. Melissa Bushman, “Cash Basis versus Accrual Accounting,” Yahoo! Voices, accessed December 2, 2011, voices.yahoo.com/cash-basis-versus-accrual-basis -accounting-147864.html?cat=3.
12. “Cash vs. Accrual Accounting,” Nolo.com, accessed December 2, 2011, http://www.nolo.com/legal-encyclopedia/cash-vs-accrual-accounting-29513.html.
13. “Accounting Quotes,” Qfinance, accessed February 14, 2012, http://www.qfinance.com/finance-and-business-quotes/accounting.
14. Walter Harrison, Charles Lungren, and Bill Thomas, Financial Accounting, 8th ed. (Boston, MA: Prentice Hall, 2010), 63.
15. “Work in Process,” BusinessDictionary.com, accessed December 2, 2011, http://www.businessdictionary.com/definition/work-in-process.html.
16. “Paid in Capital,” Investopedia, accessed December 2, 2011, http://www.investopedia.com/terms/p/paidincapital.asp.
17. “Retained Earnings,” The Free Dictionary, accessed December 2, 2011, financial-dictionary.thefreedictionary.com/Retained+Earnings.
18. Jack Welch, “A Healthy Company?,” Business Week, May 3, 2006.
19. Richard Bort, “Medium-Term Funds Flow Forecasting,” in Corporate Cash Management Handbook, ed. Richard Bort (New York: Warren Gorham & Lamont, 1990), 125.
20. “Accounting Quotes,” Qfinance, accessed February 14, 2012, http://www.qfinance.com/finance-and-business-quotes/accounting.
21. “Debt/Equity Ratio,” Investopedia, accessed December 2, 2011, http://www.investopedia.com/terms/D/debtequityratio.asp.
22. “Customer Value Analysis,” Quality Solutions, Inc., accessed December 2, 2011, http://www.qualitysolutions.com/customer_value_analysis.htm.
23. Andrew Hereth, “Accounting for Superior Customer Service,” Andrew M. Hereth Blog, accessed December 2, 2011, andrewmhereth.com/blog/accounting-for -superior-customer-service.
24. “The Importance of Cash Flow Management—Entrepreneur University,” Young Entrepreneur Blog, February 9, 2009, accessed February 14, 2012, http://www.youngentrepreneur.com/blog/entrepreneur-university/the-importance-of -cash-flow-management-entrepreneur-university.
25. “The Advantages of Using a Computerized Accounting Package such as MYOB Accounting Software,” ITS Tutorial School, accessed December 2, 2011, http://www.tuition.com.hk/computerized-accounting.htm.
26. Sheila Shanker, “Differences between Manual and Computerized Accounting Systems, Chron.com, accessed January 31, 2012, smallbusiness.chron.com/differences-between-manual-computerized-accounting-systems-3764.html.
27. John Hedtke, “Natural Selection of Low-Cost Accounting,” Accounting Technology 22, no. 5 (2006): 34–38
28. “Top 15 Accounting Software Vendors Revealed,” Business-Software.com, accessed December 2, 2011, http://www.business-software.com/erp/about-erp-financial -accounting.php.
29. Josh Morgan, “Yankee Gas Work Upsets Local Businessowners,” The Cheshire Herald (Cheshire, Connecticut), October 21, 2010
30. Josh Morgan, “Yankee Gas Work Upsets Local Business Owners,” The Cheshire Herald (Cheshire, Connecticut), October 21, 2010 | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/03%3A_Accounting_and_Finances/3.01%3A_Chapter_10-_Accounting_and_Cash_Flow.txt |
No small business, or for that matter no large business, becomes a landmark and community-gathering place overnight. It takes time along with some very sharp management skills. In the case of the Notch Store, a local legend in Cheshire, Connecticut, it took ninety years and three generations of family members.
The business began in 1921 when Pauline Salvatore recognized a business opportunity. Her husband Mike worked in the nearby quarry, and she recognized that the employees needed a location where they could buy groceries for their lunch or to bring home for dinner. She began to sell them from her living room. Soon the business located to a facility next to her home. The name Notch Store came from its use in the quarry.
A few years later, Mike left the quarry and began to work with Pauline. Over the years, the Notch Store evolved as customer needs changed. They began to expand their offerings. The physical store was enlarged. A gasoline pump was installed, and for several years, one wall of the store carried auto parts.
In 1967, Mike and Pauline’s son Frank and his wife Josephine took over the operation of the business. In the 1970s, the Notch Store extended its offerings to include deli items and lunches. It even offered a homemade cider every fall. The business grew and included its third generation of Salvatores—Frank Jr.
In the early 1990s, Frank Jr. was in charge of operations. Like any business man, he was open to suggestions from others, including his employees. One woman who worked for Frank Jr. suggested that he add breakfast sandwiches to the menu. To make these sandwiches, Frank Jr. needed a restaurant-quality stove. In one of those strange twists of life, Frank Jr. had a friend who knew Joe Namath and his wife. The Namaths were building a new home, and Joe’s wife did not like the stove in the home. Frank Jr. acquired it, and since then, the breakfast sandwich offerings have become a major staple in the Notch Store.
No business develops without encountering problems, and the Notch Store was no exception. Several years ago, a number of customers complained that they had become ill from the Notch’s cider. This was followed by several lawsuits. For most businesses, this might have been a fatal crisis and financial ruin. Fortunately, years before, Frank Jr. had listened to his brother Robert’s advice (Robert was in the insurance industry). The Notch Store had \$2.3 million in insurance coverage, which was more than enough to ensure its survival. For several reasons, including recognition of the risk of serving food to the public, the Notch Store has adopted a limited liability corporation format. Even with the best of financial planning and risk reduction strategies, many businesses have to deal with factors beyond their control. The recent economic downturn has meant that there is a significant reduction in new homes being built in Cheshire. This means that there are far fewer builders buying breakfasts and lunches, but Frank Jr. is coping with a small line of credit at a local bank. The future is still bright for the Notch Store and so is the possibility of it continuing into a fourth generation.Frank Salvatore (owner), in discussion with the authors.
The Importance of Financial Management in Small Business
Learning Objectives
1. Understand the difference between accounting and finance for small businesses.
2. Understand the major activities of finance.
3. Understand how finance can affect the selection of a business form.
4. Understand the various sources that can be used to finance the start-up operations of a business.
5. Understand what factors might affect the extent to which a firm is financed by either debt or equity.
Chapter 10 “Accounting and Cash Flow” discusses the critical importance of a small business owner understanding the fundamentals of accounting—“the language of business.” This chapter examines finance and argues that the small business owner should acquire a basic understanding of some key principles in this discipline. One question that might come to someone’s mind immediately is as follows: “What is the difference between accounting and finance?” As an academic discipline, finance began in the early decades of the twentieth century. We have already seen that accounting predates the formal study of finance by millennia.[1] Yet some have argued that accounting should be seen as a subset of finance.[2]. Others have argued that both accounting and finance should be seen as subdisciplines of economics. Not surprisingly, others have argued in favor of the primacy of accounting. If we get beyond this debate, we can see that accounting is involved with the precise reporting of the financial position of a firm through the financial statements, which is presented in Chapter 10 “Accounting and Cash Flow”. The accounting function is expected to collect, organize, and present financial information in a systematic fashion. Finance can be seen as “the science of money management” and consists of three major activities: financial planning, financial control, and financial decision making. Financial planning deals with the acquisition of adequate funds to maintain the operations of a business and making sure that funds are available when needed. Control seeks to assure that assets are being efficiently used. Decision making is associated with determining how to acquire funds, where to acquire funds, and how those funds should be used and within the context of the risk assessment of the aforementioned decisions. As an academic discipline, finance has grown tremendously over the last four decades.
Much of the work produced during this period possessed both an esoteric analytical quality and profound practical consequences. One only has to look at newspapers and the business press, during the last few years, to see how financial theory (efficient market hypothesis) and financial models (options pricing, derivatives, and arbitrage models) have played a dominant role in the global economy. Fortunately, most small businesses have no need to directly involve themselves with these analytical abstractions. But this does not mean that small business owners do not need to concern themselves with fundamental issues of financing their firms.
Impact of Organization Type on Finance Decisions
Selecting the form of business organization that is adopted by a business depends on many factors. One could begin by anticipating the eventual size and nature of the business.[3] The complexity of a business may dictate the type of business organization that is adopted. However, many of the factors that go into this determination are either directly or indirectly financial in nature. The indirect factors are as follows: the extent to which a business owner wishes to attain control of the business, the relationship that the owner would have with partners or investors, and the perceived risk associated with the business. This last factor is tied to the question of the extent to which the owner will invest his or her own money and assets. The direct financial factors that go into selecting the type of the business organization include the following: expected profits or losses, tax issues, the vulnerability and threat from lawsuits, and the ability to extract profits from the business for the owner’s use. The federal government recognizes six forms of business organizations for tax purposes: sole proprietorship, partnership, C-corporation,S-corporation, trust, and nonprofit. The last two are unlikely to be adopted by small businesses. It is useful to examine the financial implications of organizing along the remaining four basic formats.
Sole Proprietorship
Many small businesses operated by a single individual adopt sole proprietorship format of business organization. It is the most basic type of business organization. It is also the least expensive to create and the easiest to operate and dissolve. Sole proprietorships can be incorporated if the owner so desires. Not being a legal entity, single scratch sole proprietorships disappear after the death of the owner. This type of business is essentially a format for a single-person business (although many have between one and ten employees), where the owner makes all the decisions related to the business’s operations. The owner can extract all profits from the business for his or her personal use, or the owner can decide to reinvest any portion of the profits back into the business. It is interesting to know that 70 percent of all businesses in the United States are sole proprietorships yet they only produce 20 percent of all the nation’s profits.[4] Because a single proprietorship is not a legal entity, any income generated by the business goes directly on the owner’s personal tax return. However, the single owner is also personally responsible for any debts that the business acquires. This means that the owner may put his or her own personal assets at risk. In addition, this business organization means unlimited liability for its owner. The format means that there is very little opportunity to raise funds from sources other than the owner’s own capital or consumer loans.
Partnerships
Partnerships generally are unincorporated businesses. From a financial standpoint, partnerships offer a few advantages over sole proprietorship. By having more than one owner (investor), it is often easier to raise additional capital. In some businesses, such as law firms and accounting firms, the prospect of becoming a partner may be an attractive inducement to gain employees. There are several versions of partnerships.
The general partnership is composed of two or more owners who contribute the initial capital of the business and share in the profits and any losses. It is similar to a sole proprietorship in that all partners are personally responsible for all the debts and the liabilities of the business. A general partnership is comparable to a sole proprietorship in that neither is a taxable entity; therefore, the partners’ profits are taxed as personal income. They can deduct any business losses from their personal income taxes. The exact proportion of ownership of the firm is generally found in a written document known as the partnership agreement.
A limited partnership is a business that may have several general partners and several more limited partners. The major difference with a general partnership is that the limited partners do not have unlimited liability. Their losses are limited to their original investment in the business. Common practice means that these limited partners do not play a major decision-making role in the life of the business.
C-Corporations
Selecting a C-corporation form of business entails more effort and expense in creating this format. Corporations must be chartered by the state in which they are headquartered. Corporations are viewed as legal entities, meaning that they can enter into legal agreements with individuals and other corporations. They are also subject to numerous local and state regulations. This often results in extensive paperwork that can be costly. Corporations are owned by their shareholders. The shareholders are liable only for their original investment in the business. They cannot be sued for more than that amount. One of the major advantages of adopting a corporate format is that in this type of business, it is sometimes much easier to raise capital through either debt or the issuance of stock. Profits derived from this type of business are taxed at the corporate rate. It is important to note that dividends paid to shareholders, unlike interest expenses, are not deductible. So in a real sense, this form of income is doubly taxed.
S-Corporations
The S-corporation is a special format designed to eliminate the problem of double taxation that one might find with a C-corporation format. It first differs from a C-corporation in that it is limited to a hundred shareholders, although it can be created with just one shareholder. If a shareholder is an employee of the business and contributes any service to the business, then the corporation is required to pay that individual a salary. The term that is used is “reasonable” salary. This definition may vary under several conditions. A failure to comply with this ambiguous definition of “reasonable” salary means that the IRS can reclassify the profits as wages and tax the amount at the personal income rate.
Limited Liability Company
A limited liability company is an organizational form that can be limited to a single individual or several other owners or shareholders. Like a general partnership, there is a requirement for documents that define the distribution of responsibilities, profits, or losses. Generally, the members of a limited liability company are liable for the debts of the company. This format may provide tax and financial benefits for the participants. This format cannot be used in the banking or insurance industries.
Acquisition of Funds
Capital is the lifeblood of all businesses. It is needed to start, operate, and expand a business. Capital comes from several sources: equity, debt, internally generated funds, and trade credits (see Figure 11.1 “Sources of Capital”).
Figure 11.1 Sources of Capital
Equity financing raises money by selling a certain share of the ownership of the business. It involves no explicit obligation or expectation, on the part of the investors, to be repaid their investment. The value of equity financing lies in the partial ownership of the business.
Perhaps the major source of equity financing for most small start-up businesses comes from personal savings. The term bootstrapping refers to using personal, family, or friends’ money to start a business.[5] The use of one’s own money (or that of family and friends) is a strong indicator that a business owner has a strong commitment to and belief in the success of the business. If a business is financed totally from one’s personal savings, that means the owner or the operator has total control of the business.
If a business is structured as a corporation, it may issue stock. Generally, two major types of stock may be issued: common stock and preferred stock. It should be noted that in most cases, owners of common stock have what are known as voting rights. They have a proportional vote (directly related to the number of shares they own) for members of the board of directors. Preferred stock does not carry with it voting rights, but it has a form of guaranteed dividend.
Corporations that issue stock must comply with several steps to meet both federal and state statutes, including the following: outlines to issue stock to shareholders, determining the price and number of shares to be issued, creating stock certificates; developing a record to record all stock transactions; and meeting all federal and state securities requirements.[6] Smaller businesses may choose to issue stock only to those who were involved in the initial investment of the business. In such cases, one generally does not have to register these securities with state or federal agencies. However, one may be required to fill out all the forms.[7]
Venture capitalists are looking for substantial returns on their initial investment—five, ten, sometimes even twenty-five times their original investment. They will be looking for firms that can rapidly generate significant profits or significant growth in sales. Angel investors may be more attracted to their interest in the small business concept than in reaping significant returns. This is not to say that they are not interested in recouping their original investment with some type of significant return. It is much more likely that angel investors, as compared to venture capitalists, will play a much more active role in the decision-making process of the small business.
One area for possible capital infusion into a small business may come from a surprising source. Many students (and some adults) may find funding to start up a business through business plan competitions. These competitions are often hosted by colleges and universities or small business associations. The capital investment may not be large, but it might be enough to start very small businesses.
Debt financing represents a legal obligation to repay the original debt plus interest. Most debt financing involves a fixed payment schedule to repay both principal and interest. A failure to meet the schedule has serious consequences, which might include the bankruptcy of the business. Those who provide debt financing expect that the principal will be repaid with interest, but they are not formal investors in the business.
There are numerous sources for debt financing. Some small businesses begin with financing by borrowing from friends and family. Some firms may choose to finance business operations by using either personal or corporate credit cards. This approach to financing can be extraordinarily expensive given the interest rates charged on credit cards and the possibility that the credit card companies may change (by a significant amount) the credit limit associated with the credit card.
The largest source of debt financing for small businesses in the United States comes from commercial banks.[footnote]“How Will a Credit Crunch Affect Small Business Finance?,” Federal Reserve Bank of San Francisco, March 6, 2009, accessed December 2, 2011, www.frbsf.org/publications/economics/letter/2009/el2009-09.html.[/footnote] Bank lending can take many forms. The most common loan specifies the amount of money to be repaid within a specific time frame for a specific interest rate. These loans can be either secured or unsecured. Secured loans involve pledging some assets—such as a home, real estate, machinery, and plant—as collateral. Unsecured loans provide no such collateral. Because they are riskier for the bank, they generally have higher interest rates. For a more comprehensive discussion of bank loans, see Section 10.2.1 “Relationships with Bank and Bankers”.
The Small Business Administration (SBA) has a large number of programs designed to help small businesses. These include the business loan programs, investment programs, and bonding programs. The SBA operates three different loan programs. It should be understood that the SBA does not make the loan itself to a small business but rather guarantees a portion of the loan to its partners that include private lenders, microlending institutions, and community development organizations. To secure one of these loans, the borrower must meet criteria set forth by the SBA. It should be recognized that these SBA loan rules and guidelines can be altered by the US Congress and are dependent on prevailing economic and political conditions. The following subsections briefly describe some of the loan programs used by the SBA.
(a) Loan Programs
This class of loans may be used for a variety of reasons, including the purchase of land, buildings, equipment, machinery, supplies, or materials. It may also be used for long-term working capital (paying accounts payable or the purchase of inventory). It may even be used to purchase an existing business. This class of loans cannot, however, be used to refinance existing debt, to pay delinquent taxes, or to change business ownership.
• Special-purpose loans program. These loans are designed to assist small businesses for specific purposes. They have been used to help small businesses purchase and incorporate pollution control systems, develop employee stock ownership plans, and aid companies negatively impacted by the North American Free Trade Agreement (NAFTA). It includes programs such as the CAPLines, which provide assistance to businesses for meeting their short-term working capital needs. There is also the Community Adjustment and Investment Program. This program is designed to assist businesses that might have been adversely impacted by NAFTA.
• Express and pilot programs. These loan programs are designed to accelerate the process of providing loans. SBA Express can respond to a loan application within thirty-six hours while also providing lower interest rates.
• Community express programs. These programs are designed to assist borrowers whose businesses are located in economically depressed regions of the country.
• Patriot express loans. These loans are designed to assist members of the US military who wish to create or expand a small business. These loans have lower interest rates and can be used for starting a business, real estate purchases, working capital, expansions, and helping the business if the owner should be deployed.
• Export loan programs. Given the remarkable fact that 70 percent of American exporters have less than twenty employees, it is not surprising that the SBA makes a special effort to support these businesses by providing specialized loan programs. These programs include the following:
• Export Express Program. This program has a rapid turnaround time to support export-based activities. It can provide for funds up to \$500,000 worth of financing. Financing can be either a term loan or a line of credit.
• Export Working Capital Program. A major challenge that small exporters face is the fact that many American banks will not provide working capital advances on orders, receivables, or even letters of credit. This SBA program assures up to the 90 percent of a loan so as to enhance a business’s export working capital.
• SBA and Ex-Im Bank Coguarantee Program. This is an extension of the Export Working Capital Program and deals with expanding a business’s export working capital lines up to \$2 million.
• International Trade Loan Program. This program, with a maximum guarantee of \$1.75 million, enables small businesses to start an exporting program, enlarge an exporting program, or deal with the consequences of competition from overseas imports.
Another source of debt financing is the issuance of bonds. Bonds are promissory notes. There are many forms of bonds, and here we discuss only the most basic type. The fundamental format of the bond is that it is a debt instrument that promises to repay a fixed amount of money within a given time frame while providing interest payments on a regular basis. The issuance of bonds is generally an option available to businesses with a corporation format. It also requires extensive legal and financial preparations.
Another source of capital is the generation of internal funding. This simply means that a business plows its retained earnings back into the business. This is a viable source of capital when a business is highly profitable.
The last source of capital is trade credit. Trade credit involves purchasing supplies or equipment through financing made available by vendors. This approach may allow someone to acquire inventory of materials and supplies without having the full price at the time of purchase. Some analysts say that trade credit is the second largest source of financing for small businesses after borrowing from banks.[8] Trade credit is often a vital way of securing supplies.
Trade credit is often expressed in terms of three important numbers—a discount rate, the number of days for one to pay to qualify for the discount, and the number of days on which the bill must be paid. As an example, a trade credit offered by a supplier might be listed as 5/5/30. This translates into a 5 percent discount if the bill is paid within five days of the issuance. The third number means that the bill must be paid in full within thirty days.
Video Clip 11.1 How to Raise Capital: The #1 Skill of an Entrepreneur
Describes what an entrepreneur needs to do in order to acquire capital for the firm.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.2 Pat Gage: Getting Business Financing for a Small Business
Voice-over PowerPoint identifies where a small business owner can acquire funding.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.3 How to Finance a Business: How to Get Start-Up Business Financing
Examines the use of bank financing for the small business.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.4 Financing a New Business: How to Find Government Small Business Grants
Locate places to find small business grants through search engines with ideas from a certified public accountant in this free video on new business financing.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.5 The Role of Credit Cards in Small Business Financing
Congressional testimony that warns of the use of using credit cards to finance small businesses.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.6 Financial Analysis for Small-Business Owners
This excerpt from the popular video learning series at BusinessBuffet.com introduces the core concepts behind financial analysis for small business.
https://www.youtube.com/watch?v=Yyq4X71H5Fw
Web Resources
• Financing Small Business Portal: Discusses financing opportunities. www.businessfinance.com/
• Credit Loans for Small Businesses: The Chase portal—one provider of loans for small businesses.
www.chase.com/index.jsp?pg_name=ccpmapp/smallbusiness/credit_loans/page/bb_lending
• Five Ways to Finance a Business in Difficult Financial Times: Alternative ways of financing when banks are not lending.
biztaxlaw.about.com/od/financingyourstartup/tp/financingsmallbiz.htm
Capital Structure: Debt versus Equity
A critical component of financial planning for any business is determining the extent to which a firm will be financed by debt and by equity. This decision determines the financial leverage of a business. Many factors enter into this decision, particularly for the small business. From the classic economic and finance perspective, one should evaluate the cost of both debt and equity. Debt’s cost centers largely on the interest rate associated with a specific debt. Equity’s cost includes ceding control to other equity partners, the cost of issuing stock, and dividend payments. One should also consider the fact that the interest payment on debt is deductible and therefore will lower a business’s tax bill.[9] Neither the cost of issuing stock nor dividend payments is tax deductible.
Larger businesses have many more options available to them than smaller enterprises. Although this is not always true, larger businesses can often arrange for larger loans at more favorable rates than smaller businesses.[10] Larger businesses often find it easier to raise capital through the issuance of stock (equity).
By increasing a business’s proportion of debt, its financial leverage can be increased. There are many reasons for attempting to increase a business’s financial leverage. First, one is growing the business with someone else’s money. Second, there is the deductible nature of interest on debt. Third, as more clearly shown in Section 11.3.2 “Capital Structure Issues in Practice”, increasing one’s financial leverage can have a positive impact on the business’s return on equity. For all these benefits, however, there is the inescapable fact that increasing a business’s debt level also increases a business’s overall risk. The term financial leverage can be seen as being comparable to the base word—lever. Levers are tools that can amplify an individual’s power. A certain level of debt can amplify the “lifting” power of a business (see the upper portion of Figure 11.2 “Acceptable and Unacceptable Levels of Leverage”). However, beyond a certain point, the debt may be out of reach, and therefore the entire lifting power of financial leverage may be lost (see the lower portion of Figure 11.2 “Acceptable and Unacceptable Levels of Leverage”). Beyond the loss of lifting power, the assumption of too much debt may lead to an inability to pay the interest on the debt.
Figure 11.2 Acceptable and Unacceptable Levels of Leverage
This major issue for small businesses—determining how to raise funds through either debt or equity—often transcends economic or financial decisions. For many small business owners, the ideal way of financing business growth is through generating internal funds. This means that a business does not have to acquire debt but has generated sufficient profits from its operations. Unfortunately, many small businesses, particularly at the beginning, cannot generate sufficient internal funds to finance areas such as product development, the acquisition of new machinery, or market expansions. These businesses have to rely on securing additional capital debt, equity, or some combination of both.
Many individuals start small businesses with the express purpose of finding independence and control over their own economic and business lives. This desire for independence may make many small business owners averse to the idea of equity financing because that might mean ceding business control to equity partners.[11] Another issue that makes some small business owners averse to acquiring additional equity partners is the simple fact that the acquisition of these partners means less profit to the business owner. This factor in the control issue must be considered when the small business owner is looking to raise additional capital through venture capitalist and angel investors.[12]
A recent research paper [13] examined the relationship between profitability and sources of financing for firms that had fewer than twenty-five employees. It found several rather interesting results:
• Firms that use only equity have a low probability of being profitable compared to firms that use only business or personal debt.
• Firms owned by females and minority members relied less on personal debt than male and minority owners.
• Female owners will be more likely to rely on equity from friends and family than their male counterparts.
• Firms that rely exclusively on personal savings to finance business operations will more likely be profitable than firms using equity forms of debt.
Web Resources
• Capital Structure: Definition and explanation of capital structure.
www.enotes.com/capital-structure-reference/capital-structure-178334
• Capital Structure from an Investor’s Perspective: This reviews how an investor would interpret a business’s capital structure.
beginnersinvest.about.com/od/financialratio/a/capital-structure.htm
Key Takeaways
• Business owner must be aware of the implications of financing their firms.
• Owners should be aware of the financial and tax implications of the various forms of business organizations.
• Business owners should be aware of the impact of financing their firms through equity, debt, internally generated funds, and trade credit.
• Small-business owners should be aware of the various loans, grants, and bond opportunities offered by the SBA. They should also be aware of the restrictions associated with these programs.
Exercises
1. Interview the owners of five local businesses and ask them what business organizational format they use and why they adopted that form.
2. Ask them how they initially financed the start-up of their businesses.
3. Ask these same owners how they prefer to finance the firm. (Note that most owners will probably not want to go into any detail about the financial operations of their businesses.)
4. Ask them if they have had any experience with any SBA loan program and if they have any reactions to these programs.
Financial Control
Learning Objectives
1. Learn about the importance of cultivating a relationship with a banker.
2. Understand the elements of the CAMPARI approach to evaluating a loan.
Relationships with Bank and Bankers
One often hears the following standard complaint of small businesses: bankers lend money only to those businesses that do not need the money. The inverse of this complaint from the bank’s standpoint might be that small businesses request money only when they are least likely to be able to repay it. The conflict between small businesses and bankers may stem from a misunderstanding of the respective roles of both groups. At face value, it might appear—particularly to small businesses—that bankers are investing in their companies.
Under normal conditions, bankers are extremely risk averse. This means they are not investors anticipating a substantial return predicated on the risks associated with a particular business. Bankers lend money with the clear expectation that they will be repaid both principal and interest. It is in the interest of both parties to transcend these two conflicting perceptions of the role of bankers in the life of a small business. The key way is for the small business owner to try to foster improved communications with a banker. This communication promoted by the small business owner should become the basis of a solid working relationship with the bank. Most often, this means developing a personal relationship with the loan officer of the bank, which is sometimes a problematic proposition. Bank loan officers are often moved to different branches, or they may change jobs and work for different banks. It should be the responsibility of the small business owner to maintain frequent contact with whoever is representing the bank. This should involve more than just providing quarterly statements. It should include face-to-face discussions and even asking the officer to tour a business’s facilities. The point is to personalize the working relationship between the two parties. “Ideally, it’s a human relationship as well as a business relationship,” says Bill Byne, an entrepreneur and author of Habits of Wealth.[14]
Although bankers and loan officers will rely heavily on data related to the creditworthiness of a small business, they will also consider the trustworthiness and integrity of the business owner. This intangible sense that a business owner is a worthy credit risk may play a determinant role in whether a loan is approved with the extension of a credit line. This notion of integrity has to be built over time. It is predicated on projecting an image that you can be counted on to honor what you say, know the right thing to do to make the business a success, and be able to execute the correct decisions.
It is sometimes said that bankers, when reviewing a perspective loan applicant, think of the drink “CAMPARI” which stands for the following:
• Character. As previously stated, bankers will consider the issue of personal integrity. Part of that definition of integrity will include a sense of professionalism, which can be reflected in one’s attitude and dress. Bankers will also review one’s history as a business leader, namely one’s track record of success. This notion of character may also be extended to the upper echelon of the management team of a small business.
• Ability. The bank’s prime concern is with repayment of the principal and the interest of a loan. The loan application should clearly demonstrate a business’s ability to repay the loan. All support materials should be brought to bear to prove to the banker that the loan will not be defaulted on and will be paid in a timely fashion.
• Means. This refers to a business’s ability to function in a way so that it can repay the loan. Bankers must be convinced of this crucial point. The best way to do this is by providing a comprehensive business plan with detailed numbers that indicate the business’s ability to repay the loan. The business plan should also include the business strategy and the business model that will be employed to convince the banker of the validity of the overall plan.
• Purpose. Bankers want to know for what purpose the borrowed money will be used. You should never request a loan with the argument that having more money is better for the business than having less money. You should clearly identify how the money will be used, such as purchasing a piece of capital equipment. Having done that, you should also indicate how the acquisition of the capital equipment will positively affect the bottom line of the business.
• Amount. It would be extraordinarily inadvisable to begin a request for a business loan by saying “I need some money.” It is very important that you specify the exact amount of the loan and also justify how you determined this amount of money. As an example, you might want to identify a particular piece of capital equipment that you plan to acquire. How did you determine its price? You should be able to address what additional expenditures might be required—such as training on the use of the equipment. The greater the degree of precision that is brought to this proposal, the greater the confidence the bank might have in granting the loan.
• Repayment. This refers to demonstrating an ability to repay both the interest and the principal. Again, detailed documentation, such as sales projections, profit margins, and projected cash flows, is essential if you wish to secure the loan. It is important when generating these data that you try to be as honest as possible. Extremely positive projections may be misleading. Worse still, if they are misleading and inaccurate, it may result in the business defaulting on the loan and perhaps losing the business.
• Insurance. Even the most scrupulously developed sales and profit projections might not pan out. It would be extraordinarily useful to show contingency plans to the bank that would indicate how you would repay the loan in the event that the scenarios that you have identified do not come to fruition.
One should recognize that a good relationship with the bank can yield benefits above and beyond credit lines and business loans. Bankers can serve as interlocutors, connecting you to potential customers, suppliers, and other investors. A good working relationship with a bank can be the best reference a business could have. This is particularly true in the current business climate where bankers have significantly restricted lending to small businesses.
Key Takeaways
• Any business owner must be aware that bankers consider several factors when considering a loan decision.
• Business owners should be aware of their own and their business’s creditworthiness.
• Business owners should be aware that bankers appreciate precision, particularly when it comes to the exact size of the loan, its purpose, and how it will be repaid.
Exercises
1. Arrange an interview with a loan officer at a local bank. Ask him or her what factors are considered when evaluating a small business loan for
1. a start-up business
2. a line-of-credit
3. an equipment purchase
4. a real estate purchase
2. Ask him or her how the bank evaluates the risk associated with these loans.
3. Ask the loan officer what might constitute a “red flag” that would mean that the loan would not be approved.
Financial Decision Making
Learning Objectives
1. Learn the importance of a breakeven analysis.
2. Understand how to conduct a breakeven analysis.
3. Understand the potential power and danger of financial leverage.
4. Learn how changing financial leverage can affect measures of profitability, such as ROA and ROE.
5. Learn how to use scenarios to evaluate the impact of various levels of financial leverage.
Break-even Analysis
A break-even analysis is remarkably useful to someone considering starting up a business. It examines a business’s potential costs—both fixed and variable—and then determines the sales volume necessary to produce a profit for given selling price.[15] This information enables one to determine if the entire concept is feasible. After all, if one has to sell five million shoes in a small town to turn a profit, one would immediately recognize that there may be a severe problem with the proposed business model.
A break-even analysis begins with several simplifying assumptions. In its most basic form, it assumes that you are selling only one product at a particular price, and the production cost per unit is constant over a wide range of values. The purpose of a break-even analysis is to determine the sales volume that is required so that you neither lose money nor make a profit. This translates into a situation in which the profit level is zero. Put in equation form, this simply means
total revenue − total costs = \$0.
By moving terms, we can see that the break-even point occurs when total revenues equal total costs:
total revenue = total costs.
We can define total revenue as the selling price of the product times the number of units sold, which can be represented as follows:
total revenue (TR) = selling price (SP) × sales volume (Q)
TR = SP × Q.
Total costs are seen as being composed of two parts: fixed costs and total variable costs. Fixed costs exist whether or not a firm produces any product or has any sales and consist of rent, insurance, property taxes, administrative salaries, and depreciation. Total variable costs are those costs that change across the volume of production. As part of the simplifying assumptions of the breakeven analysis, it is assumed that there is a constant unit cost of production. This would be based on the labor input and the amount of materials required to make one unit of product. As production increases, the total variable cost will likewise increase, which can be represented as follows:
total variable costs (TVC) = variable cost per unit (VC) × sales quantity (Q)
TVC = VC × Q.
Total costs are simply the summation of fixed costs plus the total variable costs:
total costs (TC) = [fixed costs (FC) + total variable cost (TVC)]
TC = FC + TVC.
The original equation for the break-even point can now be rewritten as follows:
[selling price (SP) × sales volume (Q)] − total costs (TC) = \$0
(SP × Q) − TC = \$0.
At the break-even point, revenues equal total costs, so this equation can be rewritten as
SP × Q = TC.
Given that the total costs equal the fixed costs plus the total variable costs, this equation can now be extended as follows:
selling price (SP) × sales volume (Q) = [fixed costs (FC) + total variable costs (TVC)]
SP × Q = FC + TVC.
This equation can be expanded by incorporating the definition of total variable costs as a function of sales volume:
SP × Q = FC + (VC × Q).
This equation can now be rewritten to solve for the sales value:
(SP × Q) − (VC × Q) = FC.
Because the term sales volume is present in both terms on the left-hand side of the equation, it can be factored to produce
Q × (SP − VC) = FC.
The sales value to produce the break-even point can now be solved for in the following equation:
Q = FC / (SP − VC).
The utility of the concept of break-even point can be illustrated with the following example.
Carl Jacobs, a retired engineer, was a lifelong enthusiast of making plastic aircraft models. Over thirty years, he entered many regional and national competitions and received many awards for the quality of his model building. Part of this success was due to his ability to cast precision resin parts to enhance the look of his aircraft models. During the last ten years, he acquired a reputation as being an expert in this field of creating these resin parts. A friend of his, who started several businesses, suggested that Carl look at turning this hobby into a small business opportunity in his retirement. This opportunity stemmed from the fact that Carl had created a mold into which he could cast the resin part for a particular aircraft model; this same mold could be used to produce several hundred or several thousand copies of the part, all at relatively low cost.
Carl had experience only with sculpturing and casting parts in extremely low volumes—one to five parts at a time. If he were to create a business format for this hobby, he would have to have a significant investment in equipment. There would be a need to create multiple metal molds of the same part so that they could be cast in volume. In addition, there would be a need for equipment for mixing and melting the chemicals that are required to produce the resin. After researching, he could buy top-of-the-line equipment for a total of \$33,000. He also found secondhand but somewhat less efficient equipment. Carl estimated that the total cost of acquiring all the necessary secondhand equipment would be close to \$15,000. After reviewing the equipment specifications, he concluded that with new equipment, the unit cost of producing a set of resin parts for a model would run \$9.25, whereas the unit cost for using the secondhand equipment would be \$11.00. After doing some market research, Carl determined that the maximum price he could set for his resin sets would be \$23.00. This would be true whether the resin sets were produced with new or secondhand equipment.
Carl wanted to determine how many resin sets would have to be sold to break even with each set of equipment. For simplicity’s sake, he assumed that the initial purchase price of both options would be his fixed cost. His analysis is presented in Table 11.1 “break-even point Analysis”.
Table 11.1 break-even point Analysis
Option Fixed Costs Variable Cost Selling Price break-even point
New equipment \$33,000 \$9.25/unit \$23.00
Q = \$33,000 / (\$23.00 − \$9.25)
Q = \$33,000 / \$13.75
Q = 2,400 units
Secondhand equipment \$15.000 \$11.00/unit \$23.00
Q = \$15,000 / (\$23.00 − \$11.00)
Q = \$15,000 / \$12.00
Q = 1,250 units
From this analysis, he could see that although the secondhand equipment is not as efficient (hence the higher variable cost per unit), it will break even at a significantly lower level of sales than the new equipment. Carl was still curious about the profitability of the two sets of equipment at different levels of sales. So he ran the numbers to calculate the profitability for both sets of equipment at sales levels of 1,000 units, 3,000 units, 5,000 units, 7,500 units, and 10,000 units. The results are presented in Table 11.2 “Sales Level versus Profit Breakdown”.
Table 11.2 Sales Level versus Profit Breakdown
Secondhand Equipment New Equipment
Sales Level Revenue Fixed Cost Total Variable Costs Profit Revenue Fixed Cost Total Variable Costs Profit
1,000 \$23,000 \$15,000 \$11,000 \$(3,000) \$23,000 \$33,000 \$9,250 \$(19,250)
3,000 \$69,000 \$15,000 \$33,000 \$21,000 \$69,000 \$33,000 \$27,750 \$8,250
5,000 \$115,000 \$15,000 \$55,000 \$45,000 \$115,000 \$33,000 \$46,250 \$35,750
7,500 \$172,500 \$15,000 \$82,500 \$75,000 \$172,500 \$33,000 \$69,375 \$70,125
10,000 \$230,000 \$15,000 \$110,000 \$105,000 \$230,000 \$33,000 \$92,500 \$104,500
From these results, it is clear that the secondhand equipment is preferable to the new equipment. At 10,000 units, the highest annual sales that Carl anticipated, the overall profits would be greater with secondhand equipment.
Video Clip 11.7 Breakeven Analysis: Economics for Managers
A slide show showing breakeven calculations.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.8 Break-even Analysis
A break-even tutorial with voice-over.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.9 Perform a Break-even Analysis with Excel’s Goal Seek Tool
Shows how Excel can be used to conduct sophisticated break-even analyses.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
• Break-even Analysis
This site provides a straightforward description of break-even analysis with an example.
www.businesstown.com/accounting/projections-breakeven.asp
Capital Structure Issues in Practice
In Section 11.2 “Financial Control”, the need to balance debt and equity, with respect to financing a firm’s operations, is briefly discussed. A critical financial decision for any business owner is determining the extent of financial leverage a firm should acquire. Building a firm using debt amplifies a return of equity to the owners; however, the acquisition of too much debt, which cannot be repaid, may lead to bankruptcy, which represents a complete failure of the firm.
In the early 1950s, the field of finance tried to describe the effect of financial leverage on the valuation of a firm and its cost of capital.[16] A major breakthrough occurred with the works of Franco Modigliani and Merton Miller. Reduced to simplest form, their works hypothesized that the valuation of a firm increases as the financial leverage increases. This is true but only up to a point. When a firm exceeds a particular value of financial leverage—namely, it has assumed too much debt—the overall value of the firm begins to decline. The point at which the valuation of a firm is maximized determines the optimal capital structure of the business. The model defined valuation as a firm’s earnings before interest and taxes (EBIT) divided by its cost of capital. Cost of capital is a weighted average of a firm’s debt and equity, where equity directly relates to a firm’s stock. The reality is that this model is far more closely attuned, from a mathematical standpoint, to the corporate entity. It cannot be directly applied to most small businesses. However, the basic notion that there is some desired level of debt to equity, a level that yields maximum economic benefit, is germane, as we will now illustrate.
Let us envision a small family-based manufacturing firm that until now has been able to grow through the generation of internal funds and the equity that has been invested by the original owners. Presently, the firm has no long-term debt. It has a revolving line of credit, but in the last few years, it has not had to tap into this line of credit to any great extent. The income statement for the year 2010 and the projected income statement for 2011 are given in Table 11.3 “Income Statement for 2010 and Projections for 2011”. In preparing the projected income statement for 2011, the firm assumed that sales would grow by 7.5 percent due to a rapidly rising market. In fact, the sales force indicated that sales could grow at a much higher rate if the firm can significantly increase its productive capacity. The projected income statement estimates the cost of goods sold to be 65 percent of the firm’s revenue. This estimate is predicated on the past five years’ worth of data. Table 11.4 “Abbreviated Balance Sheet” shows an abbreviated balance sheet for 2010 and a projection for 2011. The return on assets (ROA) and the return on equity (ROE) for 2010 and the projected values for 2011 are provided in Table 11.5 “ROA and ROE Values for 2010 and Projections for 2011”.
Table 11.3 Income Statement for 2010 and Projections for 2011
2010 2011
Revenue \$475,000 \$510,625
Cost of goods sold \$308,750 \$331,906
Gross profit \$166,250 \$178,719
General sales and administrative \$95,000 \$102,125
EBIT \$71,250 \$76,594
Interest \$— \$—
Taxes \$21,375 \$22,978
Net profit \$49,875 \$53,616
Table 11.4 Abbreviated Balance Sheet
2010 2011
Total assets \$750,000 \$765,000
Long-term debt \$— \$—
Owners’ equity \$750,000 \$765,000
Total debt and equity \$750,000 \$765,000
Table 11.5 ROA and ROE Values for 2010 and Projections for 2011
2010 (%) 2011 (%)
Return on assets 6.65 7.01
Return on equity 6.65 7.01
After preparing these projections, the owners were approached by a company that manufactures computer-controlled machinery. The owners were presented with a series of machines that will not significantly raise the productive capacity of their business while also reducing the unit cost of production. The owners examined in detail the productive increase in improved efficiency that this computer-controlled machinery would provide. They estimated that demand in the market would increase if they had this new equipment, and sales could increase by 25 percent in 2011, rather than 7.5 percent as they had originally estimated. Further, the efficiencies brought about by the computer-controlled equipment would significantly reduce their operating costs. A rough estimate indicated that with this new equipment the cost of goods sold would decrease from 65 percent of revenue to 55 percent of revenue. These were remarkably attractive figures. The only reservation that the owners had was the cost of this new equipment. The sales price was \$200,000, but the business did not have this amount of cash available. To raise this amount of money, they would either have to bring in a new equity partner who would supply the entire amount, borrow the \$200,000 as a long-term loan, or have some combination of equity partnership and debt. They first approached a distant relative who has successfully invested in several businesses. This individual was willing to invest \$50,000, \$100,000, \$150,000, or the entire \$200,000 for taking an equity position in the firm. The owners also went to the bank where they had line of credit and asked about their lending options. The bank was impressed with the improved productivity and efficiency of the proposed new machinery. The bank was also willing to lend the business \$50,000, \$100,000, \$150,000, or the entire \$200,000 to purchase the computer-controlled equipment. The bank, however, stipulated that the lending rate would depend on the amount that was borrowed. If the firm borrowed \$50,000, the interest rate would be 7.5 percent; if the amount borrowed was \$100,000, the interest rate would increase to 10 percent; if \$150,000 was the amount of the loan, the interest rate would be 12.5 percent; and if the firm borrowed the entire \$200,000, the bank would charge an interest rate of 15 percent.
To correctly analyze this investment opportunity, the owners could employ several financial tools and methods, such as net present value (NPV). This approach examines a lifetime stream of additional earnings and cost savings for an investment. The cash flow that might exist is then discounted by the cost of borrowing that money. If the NPV is positive, then the firm should undertake the investment; if it is negative, the firm should not undertake the investment. This approach is too complex—for the needs of this text—to be examined in any detail. For the purpose of illustration, it will be assumed that the owners began by looking at the impact of alternative investment schemes on the projected results for 2011. Obviously, any in-depth analysis of this investment would have to entail multiyear projections.
They examined five scenarios:
1. Their relative provides the entire \$200,000 for an equity position in the business.
2. They borrow \$50,000 from the bank at an interest rate of 7.5 percent, and their relative provides the remaining \$150,000 for a smaller equity position in the business.
3. They borrow \$100,000 from the bank at an interest rate of 10 percent, and their relative provides the remaining \$100,000 for a smaller equity position in the business.
4. They borrow \$150,000 from the bank at an interest rate of 12.5 percent, and their relative provides the remaining \$50,000 for an even smaller equity position in the business.
5. They borrow the entire \$200,000 from the bank at an interest rate of 15 percent.
Table 11.6 “Income Statement for the Five Scenarios” presents the income statement for these five scenarios. (An abbreviated balance sheet for the five scenarios is given in Table 11.7 “Abbreviated Balance Sheet for the Five Scenarios”.) All five scenarios begin with the assumption that the new equipment would improve productive capacity and allow sales to increase, in 2011, by 25 percent, rather than the 7.5 percent that had been previously forecasted. Likewise, all five scenarios have the same cost of goods sold, which in this case is 55 percent of the revenues rather than the anticipated 65 percent if the new equipment is not purchased. All five scenarios have the same EBIT. The scenarios differ, however, in the interest payments. The first scenario assumes that all \$200,000 would be provided by a relative who is taking an equity position in the firm. This is not a loan, so there are no interest payments. In the remaining four scenarios, the interest payments are a function of the amount borrowed and the corresponding interest rate. The payment of interest obviously impacts the earnings before taxes (EBT) and the amount of taxes that have to be paid. Although the tax bill for those scenarios where money has been borrowed is less than the scenario where the \$200,000 is provided by equity, the net profit also declines as the amount borrowed increases.
Table 11.6 Income Statement for the Five Scenarios
Borrow \$0 Borrow \$50,000 Borrow \$100,000 Borrow \$150,000 Borrow \$200,000
Revenue \$593,750 \$593,750 \$593,750 \$593,750 \$593,750
Cost of goods sold \$326,563 \$326,563 \$326,563 \$326,563 \$326,563
Gross profit \$267,188 \$267,188 \$267,188 \$267,188 \$267,188
General sales and administrative \$118,750 \$118,750 \$118,750 \$118,750 \$118,750
EBIT \$148,438 \$148,438 \$148,438 \$148,438 \$148,438
Interest \$— \$3,750 \$10,000 \$18,750 \$30,000
Taxes \$44,531 \$43,406 \$41,531 \$38,906 \$35,531
Net profit \$103,906 \$101,281 \$96,906 \$90,781 \$82,906
Table 11.7 Abbreviated Balance Sheet for the Five Scenarios
Borrow \$0 Borrow \$50,000 Borrow \$100,000 Borrow \$150,000 Borrow \$200,000
Total assets \$965,000 \$965,000 \$965,000 \$965,000 \$965,000
Long-term debt \$— \$50,000 \$100,000 \$150,000 \$200,000
Owners’ equity \$965,000 \$915,000 \$865,000 \$815,000 \$765,000
Total debt and equity \$965,000 \$965,000 \$965,000 \$965,000 \$965,000
The owners then calculated the ROA and the ROE for the five scenarios (see Table 11.8 “ROA and ROE for the Five Scenarios”). When they examined these results, they noticed that the greatest ROA occurred when the new machinery was financed exclusively by equity capital. The ROA declined as they began to fund new machinery with debt: the greater the debt, the lower the ROA. However, they saw a different situation when they looked at the ROE for each scenario. The ROE was greater in each scenario where the machinery was financed either exclusively or to some extent by debt. In fact, the lowest ROE (the firm borrowed the entire \$200,000) was 50 percent higher than if the firm did not acquire the new equipment. A further examination of the ROE results provides a very interesting insight. The ROE increases as the firm borrows up to \$100,000 of debt. When the firm borrows more money (\$150,000 or \$200,000), the ROE declines (see Figure 11.3 “ROE for the Five Scenarios”). This is a highly simplified example of optimal capital structure. There is a level of debt beyond which the benefits measured by ROE begins to decline. Small businesses must be able to identify their “ideal” debt-to-equity ratio.
Table 11.8 ROA and ROE for the Five Scenarios
Borrow \$0 Borrow \$50,000 Borrow \$100,000 Borrow \$150,000 Borrow \$200,000
ROA 10.77% 10.50% 10.04% 9.41% 8.59%
ROE 10.77% 11.07% 11.20% 11.14% 10.84%
Figure 11.3 ROE for the Five Scenarios
The owners decided to carry their analysis one step further; they wondered if the sales projections were too enthusiastic. They were concerned about the firm’s ability to repay any loan should there be a drop in sales. Therefore, they decided to examine a worst-case scenario. Such analyses are absolutely critical if one is to fully evaluate the risk of undertaking debt. They ran the numbers to see what the results would be if there was a 25 percent decrease in sales in 2011 rather than a 25 percent increase in sales compared to 2010. The results of this set of analyses are in Table 11.9 “Income Statement for the Five Scenarios Assuming a 25 Percent Decrease in Sales”. Even with a heavy debt burden for the five scenarios, the firm is able to generate a profit, although it is a substantially lower profit compared to if sales increased by 25 percent. They examined the impact of this proposed declining sales on ROA and ROE. These results are found in Table 11.10 “ROA and ROE for the Five Scenarios under the Condition of Declining Sales”.
Table 11.9 Income Statement for the Five Scenarios Assuming a 25 Percent Decrease in Sales
Borrow \$0 Borrow \$50,000 Borrow \$100,000 Borrow \$150,000 Borrow \$200,000
Revenue \$356,250 \$356,250 \$356,250 \$356,250 \$356,250
Cost of goods sold \$195,938 \$195,938 \$195,938 \$195,938 \$195,938
Gross profit \$160,313 \$160,313 \$160,313 \$160,313 \$160,313
General sales and administrative \$71,250 \$71,250 \$71,250 \$71,250 \$71,250
EBIT \$89,063 \$89,063 \$89,063 \$89,063 \$89,063
Interest \$— \$3,750 \$10,000 \$18,750 \$30,000
Taxes \$26,719 \$25,594 \$23,719 \$21,094 \$17,719
Net profit \$62,344 \$59,719 \$55,344 \$49,219 \$41,344
Table 11.10 ROA and ROE for the Five Scenarios under the Condition of Declining Sales
Borrow \$0 Borrow \$50,000 Borrow \$100,000 Borrow \$150,000 Borrow \$200,000
ROA 6.46% 6.19% 5.74% 5.10% 4.28%
ROE 6.46% 6.53% 6.40% 6.04% 5.40%
Video Clip 11.10 Debt Financing versus Equity Financing: Which Is Best for Us?
Overview of the benefits and dangers associated with debt financing and equity financing.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.11 Capital Structure
Compares capital structure to a commercial aircraft.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.12 Lecture in Capital Structure
Explains why capital structure matters.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Video Clip 11.13 The Capital Structure of a Company
Discusses the issue of long-term and short-term debt in capital structure.
A YouTube element has been excluded from this version of the text. You can view it online here: https://pb.libretexts.org/maritime/?p=114
Key Takeaways
• A relatively simply model—breakeven analysis—can indicate what sales level is required to start making a profit.
• Financial leverage—the ratio of debt to equity—can improve the economic performance of a business as measured by ROE.
• Excessive financial leverage—too much debt—can begin to reduce the economic performance of a business.
• There is an ideal level of debt for a firm, which is its optimal capital structure.
Exercises
1. A new start-up business will have fixed costs of \$750,000 per year. It plans on selling one product that will have a variable cost of \$20 per unit. What is the product’s selling price to break even?
2. Using data from the business in Exercise 1, in its second year of operation, it adds a second selling facility, which increases the fixed cost by \$250,000. The variable cost has now decreased by \$2.50 per unit. What is the new selling price to break even?
3. Using the example in Section 10.3.2 “Capital Structure Issues in Practice”, how would the ROA and the ROE change if economic conditions made borrowing money more expensive? Specifically, what would be the impact if the interest rate on \$50,000 was 10 percent; \$100,000, 15 percent; \$150,000, 17.5 percent; and \$200,000, 20 percent?
4. Again using the example in Section 10.3.2 “Capital Structure Issues in Practice”, how much would sales have to decrease to threaten the business’s ability to repay its interest on a \$100,000 loan?
The Three Threads
Learning Objectives
1. Understand that effective and efficient financial management can enhance value provided to customers.
2. Appreciate that effective financial management can improve the firm’s cash-flow position.
3. Understand that the use of technologies can significantly reduce cost of operations and improve profitability.
Customer Value
There has been extensive discussion of the notion of market segmentation. By segmenting the market, one improves the probability that a business will be able to better serve particular customers’ needs and thus provide better customer value. From a financial perspective, there may be an equivalent notion of segmentation. Earlier discussions on market segmentation were centered on how a business could provide value to particular sets of customers. A subsequent stage of this analysis would be to examine how and if these customers can provide value to a business. No one is served if the business provides significant value to its customers but the business goes broke in the process. The financial equivalent of customer segmentation examines the profitability of different groups of customers. Some customer groups may be extremely profitable to a firm, while others produce nothing but losses. Identifying these different groups requires a commitment to accounting and a financial analysis of each customer base. The first step is to determine the margin provided by each customer group. In many cases, this is a bit of a challenge. It may require more extensive record keeping. The business may have to use activity-based costing systems. (Activity-based costing systems were developed in the late 1970s and the early 1980s.) This approach to accounting “[I]s a process where costs are assigned due to the cause and effect relationship between costs and the activity that drives the cost.”[19]
Done properly, activity-based accounting can help a business identify the true costs for serving particular customer groups and therefore identify their real profit margins. A business may discover that some customer groups are actually a source of losses for the firm.
It should be pointed out that activity-based accounting is complex, difficult to implement, and, in some instances, does not conform to the requirements of generally accepted accounting principles. This might mean that a business would have to have two coexisting accounting systems, which may be too much of a burden for the small business.
Cash-Flow Implications
It should not be too surprising to find that good financial management can benefit tremendously when a firm’s cash flow is improved. Two areas where good financial management can help would be e-procurement and factoring. E-procurement involves managing the timing of invoices to customers and from suppliers to improve the cash flow of the firm.[20] The electronic handling of orders and their associated invoices assures that customers will receive their orders in a more timely fashion. E-procurement means that fewer personnel are required to take and handle orders. This can be a tremendous source of cash saving in and of itself. E-procurement should be on any supply chain management program of a business.
Another area where good financial management can improve cash flow is factoring. The most common form of factoring is associated with a business’s accounts receivable. Trade credits involve purchasing and taking delivery of supplies now while planning to pay for it later. (See Section 11.1 “The Importance of Financial Management in Small Business” for a discussion of trade credits.) Three key numbers often identify trade credits: a discount rate for early payment, the time to pay to take advantage of the discount rate, and the date by which the entire bill must be paid. We underscore the kinds of the factoring with the following example.
A firm makes a large sale of supplies—\$200,000. The trade credit program is 2/10/60. This means that the firm will give a 2 percent discount if the customer pays the entire \$200,000 within 10 days and expects the payment of the entire \$200,000 within the next 60 days. The firm knows that its customer never exercises the discount opportunity and always pays on the last possible date. Further, let us assume that this firm is having a problem with its cash flow. It would like to expedite payment as quickly as possible but does not expect that the customer will obtain a 2 percent discount by paying within 10 days. This firm could exercise the factoring option. This business goes to another firm that would provide as much as 80 percent of the cash receivable invoice immediately for small fee. In other words, the firm would receive \$160,000 immediately rather than waiting 60 days. When its customer pays the bill, the firm would receive, in total, slightly less than the \$200,000 but would have expedited the payment and thus aided its cash flow. Factoring can be an important element in improving the overall cash flow of any firm.
Digital Technology and E-Environment Implications
We identify four sources of capital in Section 11.1 “The Importance of Financial Management in Small Business”, one of which is internally generated funds. Businesses can increase the supply of capital money by becoming more operationally efficient. Improved operational efficiency can save any organization considerable amounts of money. Many start-ups, particularly those with some technological savvy, use technology to produce significant cost savings. This recognition of the vital role of technology as a cost-saving tool came to the forefront at a recent GeeknRolla conference in London. This conference brings together new business start-ups and potential investors. There is a heavy emphasis on how new businesses (and established businesses) can successfully integrate a variety of technologies and improve their operational efficiencies. As one participant in the conference, Michael Jackson, an investor, said, “Companies that are cottoning on quickly to these tools are doing very well, and they are taking business away from those who are too slow to adapt.”[21]
The 2011 conference paid special attention to the concept of cloud computing. This term refers to having software programs and databases located on an outsourced site. As an example, rather than buying Microsoft’s Office Suite for every computer in a business, one could access a word-processing program, a spreadsheet program, or a database as needed. The firm would be charged for each use or a monthly fee rather than having to purchase an entire package. As Sharif Sakr said, “In addition to being ‘pay-as-you-go,’ cloud computing has the advantage of reducing the number of computers, servers and network connections that a small business needs.”[22]
In addition to reducing a small business’s initial commitment to an information technology (IT) infrastructure—computers, software, network systems, and IT staff—cloud computing provides some of the following additional benefits:
• Scalability. Many cloud applications allow for the growth of a business. As an example, some cloud accounting packages charge on the basis of the number of users; therefore, a company could purchase as much capability as it needed.
• Updates. Businesses do not have to worry about purchasing the latest version of the software, uninstalling the old version, and installing the latest version. This is done automatically by the vendor.
• Access. Cloud programs can be accessed wherever one has a connection to the Internet. A business is not tied to its own computer or the network where the software resides. This results in tremendous flexibility; as an example, one can access the program and the data while on the road with a client.
• Integration. Having programs and databases on the cloud facilitates multiple members of an organization successfully working together. No one has to worry whether he or she is working with the latest version of the spreadsheet or the client list.
• Security. Cloud providers recognize that securing their client’s data is a core issue for business survival. They will bring into play the required technology to ensure that every one’s data are secure and safe. They have much greater capability of assuring this than almost any small business.
• Customization. Businesses can acquire the software that they need.
• Extensions into the world of social media. More and more businesses are using various forms of social media—Facebook, Twitter, LinkedIn, and so forth—yet many small businesses lack the technological savvy to fully exploit these new avenues of marketing. Cloud providers can assist these businesses in this vital area. [23]
So how can smaller businesses aspire to efficiencies that much larger organizations have achieved through the use of IT while achieving it at a fraction of the cost? Entire accounting systems can be placed on the cloud. FreshBooks, which is free for solo location businesses, provides an accounting system that can be extended to allow business operators to submit invoices via the iPhone. Shoeboxed, another cloud-based company, allows small businesses to take digitalized receipts and turn them into invoices.
Owners and employees can more productively manage their time by using a variety of scheduling programs. TimeTrade is an effective personal scheduling assistant. It can show prospective clients available times and assist in arranging a scheduled appointment. Major companies, such as Microsoft and Google, provide cloud-based applications that can be employed by both large corporations and the smallest of businesses. Microsoft has an e-mail system—Exchange—that can be used by smaller businesses for fees as low as \$50 per month. Google Voice can translate voice mail and e-mail messages and forward them anywhere in the world. Programs such as Mail-Chimp can send information packages to any or all of a business’s clients and then automatically post the same information on the company’s Facebook and Twitter sites.
Key Takeaways
• Just as a business must identify what is of value to its customers, it should also determine how valuable its customers are to the business.
• It may not “pay” to attract and keep all customers.
• Techniques such as factoring accounts receivable may improve the cash flow of a firm.
• The use of cloud computing can significantly reduce costs and improve the financial position of a firm.
• Local, national, and international economic conditions can affect any firm. Businesses should plan on how to deal with major economic upheavals.
Exercises
1. Search the Internet to find out about the availability and price of activity-based accounting software.
2. Imagine your boss has asked you to prepare a small report on using factoring as an option in her auto parts business. Search the Internet to find out about the economics of factoring.
3. Prepare a report on accounting and finance software packages available through cloud computing. Discuss their pros, cons, and pricing structures.
Disaster Watch
If one looks at that statement at face value, the only conclusion one can come to is that failure solely rests on the shoulders of the small business owner. This is far from the full story. Small businesses can face disastrous financial situations over which they have absolutely no control. This simple fact has been brought to the forefront in the last few years with the economic downturn.
For most small businesses, the major source of external financing comes from banks. Anything that affects the banks’ ability or desire to lend to small businesses can have a profound effect. One of the first responses on the part of commercial banks to the crisis of 2008 was a severe restriction of credit. At the height of the crisis in October 2008, nearly 72 percent of large banks and 78 percent of small banks stated that they were tightening their credit standards for small businesses[24]. This slightly more restrictive approach on the part of smaller banks represented a change from some prior recessions. Berger and Udell (1994) found that during the credit crunch of 1990–92 smaller banks were more willing to lend than larger banks.[25]
The current credit crunch has even more significance for small businesses. The originator of current economic difficulties was in the US real estate industry. The result has been a significantly depressed real estate market. Many small businesses use either personal residences or business property (real estate) as the basis for collateral to secure loans. A depressed real estate market reduces the viability of this option. Other negative consequences for small businesses in this current economic environment revolve around its impact on alternatives of raising capital via commercial bank loans. In earlier credit crunches, many small businesses turned to commercial finance companies. These types of companies would lend money to small businesses that pledged assets as collateral[26]. Since the early 1990s, many of these firms either disappeared or have been absorbed by larger commercial banking institutions. Today, many of the largest firms in the United States are holding onto cash (some estimate it in the neighborhood of \$2 trillion to \$3 trillion). Their unwillingness to spend or invest is impacting smaller businesses that operate further down the supply chain. Another impact of the current economic crisis has been that many banks have changed their lending practices for credit cards. They have raised rates, raised fees, and lowered credit limits. Many small businesses are sometimes reduced to using credit cards as a basis for attaining short-term financing for purchases or meeting bills. This sudden change in the “rules of the game” for credit cards has presented many small businesses with an unexpected challenge.
None of these changes in the financial landscape were brought about by the decision making or the knowledge of entrepreneurs and small business operators. Only an extraordinarily small number of financial experts saw the crisis coming. Nonetheless, entrepreneurs and small business owners have found that they must learn to rapidly adapt to what is simply a disastrous situation. The financial lesson to be learned from the current crisis is that any business, particularly small businesses, must prepare to have alternative sources of financing available for the continued operations.
1. “Difference between Accounting and Finance,” DifferenceBetween.net, accessed February 1, 2012, http://www.differencebetween.net/business/difference-between -accounting-and-finance.
2. “Difference between Accounting and Finance,” DifferenceBetween.net, accessed February 1, 2012, http://www.differencebetween.net/business/difference-between -accounting-and-finance.
3. “Types of Business Organizations,” BusinessFinance.com, accessed December 2, 2011, http://www.businessfinance.com/books/startabusiness/startabusinessworkbook010.htm.
4. “Business Finance—by Category,” About.com, accessed December 2, 2011, bizfinance.about.com/od/income tax/a/busorgs.htm.
5. “Financing,” Small Business Notes, accessed December 2, 2011, http://www.smallbusinessnotes.com/business-finances/financing.
6. “Checklist: Issuing Stock,” San Francisco Chronicle, accessed December 2, 2011, allbusiness.sfgate.com/10809-1.html.
7. “How to Form a Corporation,” Yahoo! Small Business Advisor, April 26, 2011, accessed February 1, 2012, smallbusiness.yahoo.com/advisor/how-to-form-a-corporation -201616320.html.
8. Anita Campbell, “Trade Credit: What It Is and Why You Should Pay Attention,” Small Business Trends, May 11, 2009, accessed December 2, 2011, smallbiztrends.com/2009/05/trade-credit-what-it-is-and-why-you-should-pay-attention.html.
9. Gavin Cassar, “The Financing of Business Startups,” Journal of Business Venturing 19 (2004): 261–83
10. Lola Fabowale, Barbara Orse, and Alan Riding, “Gender, Structural Factors, and Credit Terms between Canadian Small Businesses and Financial Institutions,” Entrepreneurship Theory and Practice 19 (1995): 41–65
11. Harry Sapienza, M. Audrey Korsgaard, and Daniel Forbes, “The Self-Determination Mode of an Entrepreneur’s Choice of Financing,” in Advances in Entrepreneurship, Firm Emergence, and Growth: Cognitive Approaches to Entrepreneurship Research, ed. Jerome A. Katz and Dean Shepherd (Oxford: Elsevier JAI, 2003) 6:105–38
12. Allen N. Berger and Gregory F. Udell, “The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle,” Journal of Banking and Finance 22, no. 6–8 (1998): 613–73.
13. Rowena Ortiz-Walters and Mark Gius, “Performance of Newly Formed Micro Firms: The Role of Capital Financing Structure and Entrepreneurs’ Personal Characteristics” (unpublished manuscript), 2011.
14. “The Benefits of Making Your Banker Your Friend,” Small Business Administration, accessed December 2, 2011, http://www.sbaonline.sba.gov./smallbusinessplanner/start/financestartup/SERV_BANKERFRIEND.html.
15. “Breakeven Analysis: Know When You Can Expect a Profit,” Small Business Administration, accessed December 2, 2011, http://www.sba.gov/content/breakeven-analysis -know-when-you-can-expect-profit.
16. David Durand, “Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement,” Conference on Research in Business Finance (New York: National Bureau of Economic Research, 1952), 220
17. Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48, no. 3 (1958): 261–97
18. Franco Modigliani and Merton Miller, “Taxes and the Cost of Capital: A Correction,” American Economic Review 53 (1963): 433–43
19. Tiffany Bradford, “Activity-Based Costing,” Accounting @ Suite 101, accessed December 2, 2011, tiffany-bradford.suite101.com/activitybased-costing-abc-a52148.
20. Peter Robbins, “E-Procurement—Making Cash Flow King,” Credit Control 26, no. 2 (2005): 23–26
21. Sharif Sakr, “GeeknRolla: Tech Start-Ups Reveal Cost-Cutting Tips,” BBC Business, accessed December 2, 2011, http://www.bbc.co.uk/news/business-12962023.
22. Sharif Sakr, “GeeknRolla: Tech Start-Ups Reveal Cost-Cutting Tips,” BBC Business, accessed December 2, 2011, http://www.bbc.co.uk/news/business-12962023.
23. Eilene Zimmerman, “A Small Business Made to Seem Bigger,” New York Times, March 2, 2011, accessed December 2, 2011, http://www.nytimes.com/2011/03/03/business/smallbusiness/03sbiz.html?_r=1.
24. “How Will a Credit Crunch Affect Small Business Finance?,” Federal Reserve Bank of San Francisco, March 6, 2009, accessed December 2, 2011, http://www.frbsf.org/publications/economics/letter/2009/el2009-09.html.
25. Allen N. Berger and Gregory F. Udell, “Did Risk-Based Capital Allocate Bank Credit and Cause a Credit Crunch in the US?,” Journal of Money, Credit and Banking 26 (1994): 585–628.
26. Gregory F. Udell, Asset-Based Finance: Proven Disciplines for Prudent Lending (New York: Commercial Finance Association, 2004), 16 | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/03%3A_Accounting_and_Finances/3.02%3A_Chapter_11-_Financial_Management.txt |
Colin – DSC02066 – CC BY-SA 2.0; Pictures of Money – Piggy Bank – CC BY 2.0; Linus Bohman – Keys. – CC BY 2.0; Vicki – Sold it – CC BY-NC-ND 2.0.
Do you wonder where your money goes? Do you have trouble controlling your spending? Have you run up the balances on your credit cards or gotten behind in your payments and hurt your credit rating? Do you worry about how you’ll pay off your student loans? Would you like to buy a new car or even a home someday and you’re not sure where the money will come from? If you do have extra money, do you know how to invest it? Do you know how to find the right job for you, land an offer, and evaluate the company’s benefits? If these questions seem familiar to you, you could benefit from help in managing your personal finances. This chapter will provide that help.
Where Does Your Money Go?
Learning Objectives
1. Offer advice to someone who is burdened with debt.
2. Offer advice to someone whose monthly bills are too high.
Let’s say that you’re single and twenty-eight. You have a good education and a good job—you’re pulling down \$60K working with a local accounting firm. You have \$6,000 in a retirement savings account, and you carry three credit cards. You plan to buy a house (maybe a condo) in two or three years, and you want to take your dream trip to the world’s hottest surfing spots within five years (or, at the most, ten). Your only big worry is the fact that you’re \$70,000 in debt, mostly from student loans, your car loan, and credit card debt. In fact, even though you’ve been gainfully employed for a total of six years now, you haven’t been able to make a dent in that \$70,000. You can afford the necessities of life and then some, but you’ve occasionally wondered if you’re ever going to have enough income to put something toward that debt.[1]
Now let’s suppose that while browsing through a magazine in the doctor’s office, you run across a short personal-finances self-help quiz. There are two sets of three statements each, and you’re asked to check off each statement with which you agree:
• Part 1
• If I didn’t have a credit card in my pocket, I’d probably buy a lot less stuff.
• My credit card balance usually goes up at the holidays.
• If I really want something that I can’t afford, I put it on my credit card or sign up for a payment plan.
• Part 2
• I can barely afford my apartment.
• Whenever something goes wrong (car repairs, doctors’ bills), I have to use my credit card.
• I almost never spend money on stuff I don’t need, but I always seem to owe a balance on my credit card bill.
At the bottom of the page, you’re asked whether you agreed with any of the statements in Part 1 and any of the statements in Part 2. It turns out that you answered yes in both cases and are thereby informed that you’re probably jeopardizing your entire financial future.
Unfortunately, personal-finances experts tend to support the author of the quiz: if you agreed with any statement in Part 1, you have a problem with splurging; if you agreed with any statement in Part 2, your monthly bills are too high for your income.
Building a Good Credit Rating
So, you have a financial problem: according to the quick test you took, you’re a splurger and your bills are too high for your income. How does this put you at risk? If you get in over your head and can’t make your loan or rent payments on time, you risk hurting your credit—your ability to borrow in the future.
Let’s talk about your credit. How do potential lenders decide whether you’re a good or bad credit risk? If you’re a poor credit risk, how does this affect your ability to borrow, or the rate of interest you have to pay, or both? Here’s the story. Whenever you use credit, those you borrow from (retailers, credit card companies, banks) provide information on your debt and payment habits to three national credit bureaus: Equifax, Experian, and TransUnion. The credit bureaus use the information to compile a numerical credit score, generally called a FICO score; it ranges from 300 to 900, with the majority of people falling in the 600–700 range. (Here’s a bit of trivia to bring up at a dull party: FICO stands for Fair Isaac Company—the company that developed the score.) In compiling the score, the credit bureaus consider five criteria: payment history—do you pay your bills on time? (the most important), total amount owed, length of your credit history, amount of new credit you have, and types of credit you use. The credit bureaus share their score and other information about your credit history with their subscribers.
So what does this do for you? It depends. If you paid your bills on time, carried only a reasonable amount of debt, didn’t max out your credit cards, had a history of borrowing, hadn’t applied for a bunch of new loans, and borrowed from a mix of lenders, you’d be in good shape. Your FICO score would be high and lenders would like you. Because of your high credit score, they’d give you the loans you asked for at reasonable interest rates. But if your FICO score is low (perhaps you weren’t so good at paying your bills on time), lenders won’t like you and won’t lend you money (or would lend it to you at high interest rates). A low FICO score can raise the amount you have to pay for auto insurance and cell phone plans and can even affect your chances of renting an apartment or landing a particular job. So it’s very, very, very (the last “very” is for emphasis) important that you do everything possible to earn a high credit score. If you don’t know your score, here is what you should do: go to https://www.quizzle.com/ and request a free copy of your credit report.
As a young person, though, how do you build a credit history that will give you a high FICO score? Your means for doing this changed in 2009 with the passage of the Credit CARD Act, federal legislation designed to stop credit card issuers from treating its customers unfairly.[2] Based on feedback from several financial experts, Emily Starbuck Gerson and Jeremy Simon of CreditCards.com compiled the following list of ways students can build good credit.[3]
1. Become an authorized user on your parents’ account. According to the rules set by the Credit CARD Act, if you are under age twenty-one and do not have independent income, you can get a credit card in your own name only if you have a cosigner (who is over twenty-one and does have an income). This is a time when a parent can come in handy. Your parent could add you to his or her credit card account as an authorized user. Of course, this means your parent will know what you’re spending your money on (which could make for some interesting conversations). But, on the plus side, by piggybacking on your parent’s card you are building good credit (assuming, of course, that your parent pays the bill on time).
2. Obtain your own credit card. If you can show the credit card company that you have sufficient income to pay your credit card bill, you might be able to get your own card. It isn’t as easy to get a card as it was before the passage of the Credit CARD Act, and you won’t get a lot of goodies for signing up (as was true before), but you stand a chance.
3. Get the right card for you. If you meet the qualifications to get a credit card on your own, look for the best card for you. Although it sounds enticing to get a credit card that gives you frequent flyer miles for every dollar you spend, the added cost for this type of card, including higher interest charges and annual fees, might not be worth it. Look for a card with a low interest rate and no annual fee. As another option, you might consider applying for a retail credit card, such as a Target or Macy’s card.
4. Use the credit card for occasional, small purchases. If you do get a credit card or a retail card, limit your charges to things you can afford. But don’t go in the other direction and put the card in a drawer and never use it. Your goal is to build a good credit history by showing the credit reporting agencies that you can handle credit and pay your bill on time. To accomplish this, you need to use the card.
5. Avoid big-ticket buys, except in case of emergency. Don’t run up the balance on your credit card by charging high-cost, discretionary items, such as a trip to Europe during summer break, which will take a long time to pay off. Leave some of your credit line accessible in case you run into an emergency, such as a major car repair.
6. Pay off your balance each month. If you cannot pay off the balance on your credit card each month, this is likely a signal that you’re living beyond your means. Quit using the card until you bring the balance down to zero. When you’re first building credit, it’s important to pay off the balance on your card at the end of each month. Not only will this improve your credit history, but it will save you a lot in interest charges.
7. Pay all your other bills on time. Don’t be fooled into thinking that the only information collected by the credit agencies is credit card related. They also collect information on other payments including phone plans, Internet service, rental payments, traffic fines, and even library overdue fees.
8. Don’t cosign for your friends. If you are twenty-one and have an income, a nonworking, under-age-twenty-one friend might beg you to cosign his credit card application. Don’t do it! As a cosigner, the credit card company can make you pay your friend’s balance (plus interest and fees) if he fails to meet his obligation. And this can blemish your own credit history and lower your credit rating.
9. Do not apply for several credit cards at one time. Just because you can get several credit cards, this doesn’t mean that you should. When you’re establishing credit, applying for several cards over a short period of time can lower your credit rating. Stick with one card.
10. Use student loans for education expenses only, and pay on time. For many, student loans are necessary. But avoid using student loans for noneducational purposes. All this does is run up your debt. When your loans become due, consolidate them if appropriate and don’t miss a payment.
What if you’ve already damaged your credit score—what can you do to raise it? Do what you should have done in the first place: pay your bills on time, pay more than the minimum balance due on your credit cards and charge cards, keep your card balances low, and pay your debts off as quickly as possible. Also, scan your credit report for any errors. If you find any, work with the credit bureau to get them corrected.
Understand the Cost of Borrowing
Because your financial problem was brought on, in part, because you have too much debt, you should stop borrowing. But, what if your car keeps breaking down and you’re afraid of getting stuck on the road some night? So, you’re thinking of replacing it with a used car that costs \$10,000. Before you make a final decision to incur the debt, you should understand its costs. The rate of interest matters a lot. Let’s compare three loans at varying interest rates: 6, 10, and 14 percent. We’ll look at the monthly payment, as well as the total interest paid over the life of the loan.
\$10,000 Loan for 4 Years at Various Interest Rates
Interest Rate 6% 10% 14%
Monthly Payment \$235 \$254 \$273
Total Interest Paid \$1,272 \$2,172 \$3,114
If your borrowing interest rate is 14 percent, rather than 6 percent, you’ll end up paying an additional \$1,842 in interest over the life of the loan. Your borrowing cost at 14 percent is more than twice as much as it is at 6 percent. The conclusion: search for the best interest rates and add the cost of interest to the cost of whatever you’re buying before deciding whether you want it and can afford it. If you have to borrow the money for the car at the 14 percent interest rate, then the true cost of the car isn’t \$10,000, but rather \$13,114.
Now, let’s explore the complex world of credit cards. First extremely important piece of information: not all credit cards are equal. Second extremely important piece of information: watch out for credit card fees! Credit cards are a way of life for most of us. But they can be very costly. Before picking a credit card, do your homework. A little research can save you a good deal of money. There are a number of costs you need to consider:
• Finance charge. The interest rate charged to you often depends on your credit history; those with good credit get the best rates. Some cards offer low “introductory” rates—but watch out; these rates generally go up after six months.
• Annual fee. Many credit cards charge an annual fee: a yearly charge for using the card. You can avoid annual fees by shopping around (though there can be trade-offs: you might end up paying a higher interest rate to avoid an annual fee).
• Over-limit fee. This fee is charged whenever you exceed your credit line.
• Late payment fee. Pretty self-explanatory, but also annoying. Late payment fees are common for students; a study found students account for 6 percent of all overdraft fees.[4] One way to decrease the chance of paying late is to call the credit card company and ask them to set your payment due date for a time that works well for you. For example, if you get paid at the end of the month, ask for a payment date around the 10th of the month. Then you can pay your bill when you get paid and avoid a late fee.
• Cash advance fee. While it’s tempting to get cash from your credit card, it’s pretty expensive. You’ll end up paying a fee (around 3 percent of the advance), and the interest rate charged on the amount borrowed can be fairly high.
An alternative to a credit card is a debit card, which pulls money out of your checking account whenever you use the card to buy something or get cash from an ATM. These cards don’t create a loan when used. So, are they better than credit cards? It depends—each has its advantages and disadvantages. A big advantage of a credit card is that it helps you build credit. A disadvantage is that you can get in over your head in debt and possibly miss payments (thereby incurring a late payment fee). Debit cards help control spending. Theoretically, you can’t spend more than you have in your checking account. But be careful—if you don’t keep track of your checking account balance, it’s easy to overdraft your account when using your debit card. Prior to July 2010, most banks just accepted purchases or ATM withdrawals even if a customer didn’t have enough money in his or her account to cover the transaction. The banks didn’t do this to be nice, and they didn’t ask customers if they wanted this done—they just overdrafted the customer’s account and charged the customer a hefty overdraft fee of around \$35 through what they call an “overdraft protection program”.[5] Overdraft fees can be quite expensive, particularly if you used the card to purchase a hamburger and soda at a fast-food restaurant.
The Federal Reserve changed the debit card rules in 2010, and now banks must get your permission before they enroll you in an overdraft protection program.[6] If you opt in (agree), things work as before: You can spend or take out more money through an ATM machine than you have in your account, and the bank lets you do this. But it charges you a fee of about \$30 plus additional fees of \$5 per day if you don’t cover the overdraft in five days. If you don’t opt in, the bank will not let you overdraft your account. The downside is that you could get embarrassed at the cash register when your purchase is rejected or at a restaurant when trying to pay for a meal. Obviously, you want to avoid being charged an overdraft fee or being embarrassed when paying for a purchase. Here are some things you can do to decrease the likelihood that either would happen:[7]
• Ask your bank to e-mail or text you when your account balance is low.
• Have your bank link your debit card account to a savings account. If more money is needed to cover a purchase, the bank will transfer the needed funds from your savings to your checking account.
• Use the online banking feature offered by most banks to check your checking account activity.
A Few More Words about Debt
What should you do now to turn things around—to start getting out of debt? According to many experts, you need to take two steps:
1. Cut up your credit cards and start living on a cash-only basis.
2. Do whatever you can to bring down your monthly bills.
Figure 12.1 Visa Credit Card
Living on a cash-only basis is the first step in getting debt under control.[8]
Step 1 in this abbreviated two-step personal-finances “plan” is probably the easier of the two, but taking even this step can be hard enough. In fact, a lot of people would find it painful to give up their credit cards, and there’s a perfectly logical reason for their reluctance: the degree of pain that one would suffer from destroying one’s credit cards probably stands in direct proportion to one’s reliance on them.
As of May 2011, total credit card debt in the United States is about \$780 billion, out of \$2.5 trillion in total consumer debt. Closer to home, one recent report puts average credit card debt per U.S. household at \$16,000 (up 100 percent since 2000). The 600 million credit cards held by U.S. consumers carry an average interest rate on these cards of 15 percent.[9] Why are these numbers important? Primarily because, on average, too many consumers have debt that they simply can’t handle. “Credit card debt,” says one expert on the problem, “is clobbering millions of Americans like a wrecking ball,”[10] and if you’re like most of us, you’d probably like to know whether your personal-finances habits are setting you up to become one of the clobbered.
If, for example, you’re worried that your credit card debt may be overextended, the American Bankers Association suggests that you ask yourself a few questions:[11]
• Do I pay only the minimum month after month?
• Do I run out of cash all the time?
• Am I late on critical payments like my rent or my mortgage?
• Am I taking longer and longer to pay off my balance(s)?
• Do I borrow from one credit card to pay another?
If such habits as these have helped you dig yourself into a hole that’s steadily getting deeper and steeper, experts recommend that you take three steps as quickly as possible:[12]
1. Get to know the enemy. You may not want to know, but you should collect all your financial statements and figure out exactly how much credit card debt you’ve piled up.
2. Don’t compound the problem with late fees. List each card, along with interest rates, monthly minimums, and due dates. Bear in mind that paying late fees is the same thing as tossing what money you have left out the window.
3. Now cut up your credit cards (or at least stop using them). Pay cash for everyday expenses, and remember: swiping a piece of plastic is one thing (a little too easy), while giving up your hard-earned cash is another (a little harder).
And, if you find you’re unable to pay your debts, don’t hide from the problem, as it will not go away. Call your lenders and explain the situation. They should be willing to work with you in setting up a payment plan. If you need additional help, contact a nonprofit credit assistance group such as the National Foundation for Credit Counseling (http://www.nfcc.org).
Why You Owe It to Yourself to Manage Your Debts
Now, it’s time to tackle step 2 of our recommended personal-finances miniplan: do whatever you can to bring down your monthly bills. As we said, many people may find this step easier than step 1—cutting up your credit cards and starting to live on a cash-only basis.
If you want to take a gradual approach to step 2, one financial planner suggests that you perform the following “exercises” for one week:[13]
• Keep a written record of everything you spend and total it at week’s end.
• Keep all your ATM receipts and count up the fees.
• Take \$100 out of the bank and don’t spend a penny more.
• Avoid gourmet coffee shops.
Among other things, you’ll probably be surprised at how much of your money can become somebody else’s money on a week-by-week basis. If, for example, you spend \$3 every day for one cup of coffee at a coffee shop, you’re laying out nearly \$1,100 a year. If you use your ATM card at a bank other than your own, you’ll probably be charged a fee that can be as high as \$3. The average person pays more than \$60 a year in ATM fees, and if you withdraw cash from an ATM twice a week, you could be racking up \$300 in annual fees. As for your ATM receipts, they’ll tell you whether, on top of the fee that you’re charged by that other bank’s ATM, your own bank is also tacking on a surcharge.[14][15][16][17]
If this little exercise proves enlightening—or if, on the other hand, it apparently fails to highlight any potential pitfalls in your spending habits—you might devote the next week to another exercise:
• Put all your credit cards in a drawer and get by on cash.
• Take your lunch to work.
• Buy nothing but groceries and gasoline.
• Use coupons whenever you go to the grocery store (but don’t buy anything just because you happen to have a coupon).
The obvious question that you need to ask yourself at the end of week 2 is, “how much did I save?” An equally interesting question, however, is, “what can I do without?” One survey asked five thousand financial planners to name the two expenses that most consumers should find easiest to cut back on. Figure 12.2 “Reducible Expenses” shows the results.
Figure 12.2 Reducible Expenses
You may or may not be among the American consumers who buy thirty-five million cans of Bud Light each and every day, or 150,000 pounds of Starbucks coffee, or 2.4 million Burger King hamburgers, or 628 Toyota Camrys. Yours may not be one of the 70 percent of U.S. households with an unopened consumer-electronics product lying around.[18] And you may or may not be ready to make some major adjustments in your personal-spending habits, but if, at age twenty-eight, you have a good education and a good job, a \$60,000 income, and a \$70,000 debt—by no means an implausible scenario—there’s a very good reason why you should think hard about controlling your modest share of that \$2.5 trillion in U.S. consumer debt: your level of indebtedness will be a key factor in your ability—or inability—to reach your longer-term financial goals, such as home ownership, a dream trip, and, perhaps most important, a reasonably comfortable retirement.
The great English writer Samuel Johnson once warned, “Do not accustom yourself to consider debt only as an inconvenience; you will find it a calamity.” In Johnson’s day, you could be locked up for failing to pay your debts; there were even so-called debtors’ prisons for the purpose, and we may suppose that the prospect of doing time for owing money was one of the things that Johnson had in mind when he spoke of debt as a potential “calamity.” We don’t expect that you’ll ever go to prison on account of indebtedness, and we won’t suggest that, say, having to retire to a condo in the city instead of a tropical island is a “calamity.” We’ll simply say that you’re more likely to meet your lifetime financial goals—whatever they are—if you plan for them. What you need to know about planning for and reaching those goals is the subject of this chapter.
Key Takeaways
• Before buying something on credit, ask yourself whether you really need the goods or services, can afford them, and are willing to pay interest on the purchase.
• Whenever you use credit, those you borrow from provide information on your debt and payment habits to three national credit bureaus.
• The credit bureaus use the information to compile a numerical credit score, called a FICO score, which they share with subscribers.
• The credit bureaus consider five criteria in compiling the score: payment history, total amount owed, length of your credit history, amount of new credit you have, and types of credit you use.
• As a young person, you should do the following to build a good credit history that will give you a high FICO score.
• Become an authorized user on your parents’ account.
• Obtain your own credit card
• Get the right card for you.
• Use the credit card for occasional, small purchases
• Avoid big-ticket buys, except in case of emergency.
• Pay off your balance each month.
• Pay all your other bills on time.
• Don’t cosign for your friends.
• Do not apply for several credit cards at one time.
• Use student loans for education expenses only, and pay on time.
• To raise your credit score, you should pay your bills on time, pay more than the minimum balance due, keep your card balances low, and pay your debts off as quickly as possible. Also, scan your credit report for any errors and get any errors fixed.
• If you can’t pay your debt, explain your situation to your lenders and see a credit assistance counselor.
• Before you incur a debt, you should understand its costs. The interest rate charged by the lender makes a big difference in the overall cost of the loan.
• The costs associated with credit cards include finance charges, annual fees, over-limit fees, late payment fees, and cash advance fees.
• The Federal Reserve changed the debit card rules in 2010 and now banks must get your permission before they enroll you in an overdraft protection program.
• If you have a problem with splurging, cut up your credit cards and start living on a cash-only basis.
• If your monthly bills are too high for your income, do whatever you can to bring down those bills.
Exercise
(AACSB) Analysis
There are a number of costs associated with the use of a credit card, including finance charges, annual fee, over-limit fee, late payment fee, and cash advance fee. Identify these costs for a credit card you now hold. If you don’t presently have a credit card, go online and find an offer for one. Check out these costs for the card being offered.
Financial Planning
Learning Objectives
1. Define personal finances and financial planning.
2. Explain the financial planning life cycle.
3. Discuss the advantages of a college education in meeting short- and long-term financial goals.
4. Describe the steps you’d take to get a job offer and evaluate alternative job offers, taking benefits into account.
5. Understand the ways to finance a college education.
Before we go any further, we need to nail down a couple of key concepts. First, just what, exactly, do we mean by personal finances? Finance itself concerns the flow of money from one place to another, and your personal finances concern your money and what you plan to do with it as it flows in and out of your possession. Essentially, then, personal finance is the application of financial principles to the monetary decisions that you make either for your individual benefit or for that of your family.
Second, monetary decisions work out much more beneficially when they’re planned rather than improvised. Thus our emphasis on financial planning—the ongoing process of managing your personal finances in order to meet goals that you’ve set for yourself or your family.
Financial planning requires you to address several questions, some of them relatively simple:
• What’s my annual income?
• How much debt do I have, and what are my monthly payments on that debt?
Others will require some investigation and calculation:
• What’s the value of my assets?
• How can I best budget my annual income?
Still others will require some forethought and forecasting:
• How much wealth can I expect to accumulate during my working lifetime?
• How much money will I need when I retire?
The Financial Planning Life Cycle
Another question that you might ask yourself—and certainly would do if you were a professional in financial planning—is something like, “How will my financial plans change over the course of my life?” Figure 12.3 “Financial Life Cycle” illustrates the financial life cycle of a typical individual—one whose financial outlook and likely outcomes are probably a lot like yours.[19] As you can see, our diagram divides this individual’s life into three stages, each of which is characterized by different life events (such as beginning a family, buying a home, planning an estate, retiring). At each stage, too, there are recommended changes in the focus of the individual’s financial planning:
• In stage 1, the focus is on building wealth.
• In stage 2, the focus shifts to the process of preserving and increasing the wealth that one has accumulated and continues to accumulate.
• In stage 3, the focus turns to the process of living on (and, if possible, continuing to grow) one’s saved wealth.
Figure 12.3 Financial Life Cycle
At each stage, of course, complications can set in—say, changes in such conditions as marital or employment status or in the overall economic outlook. Finally, as you can also see, your financial needs will probably peak somewhere in stage 2, at approximately age fifty-five, or ten years before typical retirement age.
Choosing a Career
Until you’re eighteen or so, you probably won’t generate much income; for the most part, you’ll be living off your parents’ wealth. In our hypothetical life cycle, however, financial planning begins in the individual’s early twenties. If that seems like rushing things, consider a basic fact of life: this is the age at which you’ll be choosing your career—not only the sort of work you want to do during your prime income-generating years, but also the kind of lifestyle you want to live in the process.[20]
What about college? Most readers of this book, of course, have decided to go to college. If you haven’t yet decided, you need to know that college is an extremely good investment of both money and time.
Table 12.1 “Education and Average Income”, for example, summarizes the findings of a study conducted by the U.S. Census Bureau.[21] A quick review shows that people who graduate from high school can expect to increase their average annual earnings by about 49 percent over those of people who don’t, and those who go on to finish college can expect to generate 82 percent more annual income than that. Over the course of the financial life cycle, families headed by those college graduates will earn about \$1.6 million more than families headed by high school graduates who didn’t attend college. (With better access to health care—and, studies show, with better dietary and health practices—college graduates will also live longer. And so will their children.)[22]
Table 12.1 Education and Average Income
Education Average income Percentage increase over next-highest level
High school dropout \$20,873
High school diploma \$31,071 48.9%
College degree \$56,788 82.8%
Advanced higher-education degree \$82,320 45.0%
And what about the debt that so many people accumulate to finish college? For every \$1 that you spend on your college education, you can expect to earn about \$35 during the course of your financial life cycle.[23] At that rate of return, you should be able to pay off your student loans (unless, of course, you fail to practice reasonable financial planning).
Naturally, there are exceptions to these average outcomes. You’ll find English-lit majors stocking shelves at 7-Eleven, and you’ll find college dropouts running multibillion-dollar enterprises. Microsoft cofounder Bill Gates dropped out of college after two years, as did his founding partner, Paul Allen. Current Microsoft CEO Steve Ballmer finished his undergraduate degree but quit his MBA program to join Microsoft (where he apparently fit in among the other dropouts in top management). It’s always good to remember, however, that though exceptions to rules (and average outcomes) occasionally modify the rules, they invariably fall far short of disproving them: in entrepreneurship as in most other walks of adult life, the better your education, the more promising your financial future. One expert in the field puts the case for the average person bluntly: educational credentials “are about being employable, becoming a legitimate candidate for a job with a future. They are about climbing out of the dead-end job market”.[24]
Finally, does it make any difference what you study in college? To a perhaps surprising extent, not necessarily. Some career areas, such as engineering, architecture, teaching, and law, require targeted degrees, but the area of study designated on your degree often doesn’t matter much when you’re applying for a job. If, for instance, a job ad says, “Business, communications, or other degree required,” most applicants and hires will have those “other” degrees. When poring over résumés for a lot of jobs, potential employers look for the degree and simply note that a candidate has one; they often don’t need to focus on the particulars.[25]
This is not to say, however, that all degrees promise equal job prospects. Figure 14.4 “Top 25 Fastest-Growing Jobs, 2006–2016”, for example, summarizes a U.S. Bureau of Labor Statistics projection of the thirty fast-growing occupations for the years 2006–2016. Veterinary technicians and makeup artists will be in demand as never before, but as you can see, occupational prospects are fairly diverse.[26]
Figure 12.4 Top 25 Fastest-Growing Jobs, 2006–2016
Nor, of course, do all degrees pay off equally. In Table 12.2 “College Majors and Average Annual Earnings”, we’ve extracted the findings of a study conducted by the National Science Foundation on the earnings of individuals with degrees in various undergraduate fields.[27][28] Clearly, some degrees—notably in the engineering fields—promise much higher average earnings than others. Chemical engineers, for instance, can earn nearly twice as much as elementary school teachers, but there’s a catch: if you graduate with a degree in chemical engineering, your average annual salary will be about \$67,000 if you can find a job related to that degree; if you can’t, you may have to settle for as much as 40 percent less.[29] (Supermodel Cindy Crawford cut short her studies in chemical engineering because there was more money to be made on the runway.)
Table 12.2 College Majors and Average Annual Earnings
Major Average Earnings with Bachelor’s Degree Major Average Earnings with Bachelor’s Degree
Chemical engineering \$67,425 History \$45,926
Aerospace engineering \$65,649 Biology \$45,532
Computer engineering \$62,527 Nursing \$45,538
Physics \$62,104 Psychology \$43,963
Electrical engineering \$61,534 English \$43,614
Mechanical engineering \$61,382 Health technology \$42,524
Industrial engineering \$61,030 Criminal justice \$41,129
Civil engineering \$58,993 Physical education \$40,207
Accounting \$56,637 Secondary education \$39,976
Finance \$55,104 Fine arts \$38,857
Computer science \$52,615 Philosophy \$38,239
Business management \$52,321 Dramatic arts \$37,091
Marketing \$51,107 Music \$36,811
Journalism \$46,835 Elementary education \$34,564
Information systems \$46,519 Special education \$34,196
In short, when you’re planning what to do with the rest of your life, it’s a good idea to check into the fine points and realities, as well as the statistical data. If you talk to career counselors and people in the workforce, you might be surprised by what you learn about the relationship between certain college majors and various occupations. Onetime Hewlett-Packard CEO Carly Fiorina majored in medieval history and philosophy.
Financing a College Education
Let’s revisit one of the facts included in the earlier discussion: for every \$1 that you spend on your college education, you can expect to earn about \$35 during the course of your financial life cycle. And let’s say you’re convinced (as you should be) that getting a college degree is a wise financial choice. You still have to deal with the cost of getting your degree. We’re sure this won’t come as a surprise: attending college is expensive—tuition and fees have gone up sharply, the cost of books has skyrocketed, and living expenses have climbed. Many students can attend college only if they receive some type of financial aid. Though the best way to learn what aid is available to you is to talk with a representative in the financial aid office at your school, this section provides an overview of the types of aid offered to students. Students finance their education through scholarships, grants, education loans, and work-study programs.[30] We’ll explore each of these categories of aid:
• Scholarships, which don’t have to be repaid, are awarded based on a number of criteria, including academic achievement, athletic or artistic talent, special interest in a particular field of study, ethnic background, or religious affiliation. Scholarships are generally funded by private donors such as alums, religious institutions, companies, civic organizations, professional associations, and foundations.
• Grants, which also don’t have to be repaid, are awarded based on financial need. They’re funded by the federal government, the states, and academic institutions. An example of a common federal grant is the Pell Grant, which is awarded to undergraduate students based on financial need. The maximum Pell Grant award for the 2011–12 award year (July 1, 2011, to June 30, 2012) is \$5,550.[31]
• Education loans, which must be repaid, are available to students from various sources, including the federal government, states, and academic institutions. While recent problems in the credit markets have made college loans more difficult to obtain, most students are able to get the loans they need.[32] The loans offered directly to undergraduate students by the federal government include the need-based, subsidized Federal Stafford, the non–need-based unsubsidized Federal Stafford, and the need-based Federal Perkins loans. With the exception of the unsubsidized Federal Stafford, no interest accrues while the student is enrolled in college at least part time. There are also a number of loans available to parents of students, such as the Federal Parent PLUS program. Under this program, parents can borrow federally guaranteed low-interest loans to fund their child’s education.
• Work-study is a federally sponsored program that provides students with paid, part-time jobs on campus. Because the student is paid based on work done, the funds received don’t have to be repaid.
Find a Great Job
As was highlighted earlier, your financial life cycle begins at the point when you choose a career. Building your career takes considerable planning. It begins with the selection of a major in college and continues through graduation as you enter the workforce full time. You can expect to hold a number of jobs over your working life. If things go as they should, each job will provide valuable opportunities and help you advance your career. A big challenge is getting a job offer in your field of interest, evaluating the offer, and (if you have several options) selecting the job that’s right for you.[33]
Getting a Job Offer
Most likely your college has a career center. The people working there can be a tremendous help to you as you begin your job search. But most of the work has to be done by you. Like other worthwhile projects, your job search project will be very time-consuming. As you get close to graduation, you’ll need to block out time to work on this particularly important task.
The first step is to prepare a résumé, a document that provides a summary of educational achievements and relevant job experience. Its purpose is to get you an interview. A potential employer will likely spend less than a minute reviewing your résumé, so its content should be concise, clear, and applicable to the job for which you’re applying. For some positions, the person in charge of hiring might read more than a hundred résumés. If you don’t want your résumé kicked out right away, be sure it contains no typographical or grammatical errors. Once you’ve completed your résumé, you can use it to create different versions tailored to specific companies you’d like to work for. Your next step is to write a cover letter, a document accompanying your résumé that explains why you’re sending your résumé and highlights your qualifications. You can find numerous tips on writing résumés and cover letters (as well as samples of both) online. Be sure your résumé is accurate: never lie or exaggerate in a résumé. You could get caught and not get the job (or—even worse—you could get the job, get caught, and then get fired). It’s fairly common practice for companies to conduct background checks of possible employees, and these checks will point out any errors. In effect, says one expert, “you jeopardize your future when you lie about your past”.[34]
After writing your résumé and cover letter, your next task is to create a list of companies you’d like to work for. Use a variety of sources, including your career services office and company Web sites, to decide which companies to put on your list. Visit the “career or employment” section of the company Web sites and search for specific openings.
You could also conduct a general search for positions that might be of interest to you, by doing the following:
• Visiting career Web sites, such as Monster.com, Wetfeet.com, or Careerbuilder.com (which maintain large databases of openings for all geographical areas)
• Searching classified ads in online and print newspapers
• Attending career fairs at your college and in your community
• Signing up with career services to talk with recruiters when they visit your campus
• Contacting your friends, family, and college alumni and letting them know you’re looking for a job and asking for their help
Once you spot a position you want, send your résumé and cover letter (tailored to the specific company and job). Follow up in a few days to be sure your materials got to the right place, and offer to provide any additional information. Keep notes on all contacts.
Figure 12.5 Preparing for an Interview
Preparing well for an interview can make it easier to relax and help the interviewer get to know you.[35]
When you’re invited for an interview, visit to the company’s Web site and learn as much as you can about the company. Practice answering questions you might be asked during the interview, and think up a few pertinent questions to ask your interviewer. Dress conservatively—males should wear a suit and tie and females should wear professional-looking clothes. Try to relax during the interview (though everyone knows this isn’t always easy). Your goal is to get an offer, so let the interviewer learn who you are and how you can be an asset to the company. Send a thank-you note (or thank-you e-mail) to the interviewer after the interview.
Evaluating Job Offers
Let’s be optimistic and say that you did quite well in your interviews, and you have two job offers. It’s a great problem to have, but now you have to decide which one to accept. Salary is important, but it’s clearly not the only factor. You should consider the opportunities the position offers: will you learn new things on the job, how much training will you get, could you move up in the organization (and if so, how quickly)? Also consider quality of life issues: how many hours a week will you have to work, is your schedule predictable (or will you be asked to work on a Friday night or Saturday at the last minute), how flexible is your schedule, how much time do you get off, how stressful will the job be, do you like the person who will be your manager, do you like your coworkers, how secure is the job, how much travel is involved, where’s the company located, and what’s the cost of living in that area? Finally, consider the financial benefits you’ll receive. These could include health insurance, disability insurance, flexible spending accounts, and retirement plans. Let’s talk more about the financial benefits, beginning with health insurance.
• Employer-sponsored health insurance plans vary greatly. Some cover the employee only, while others cover the employee, spouse, and children. Some include dental and eye coverage while others don’t. Most plans require employees to share some of the cost of the medical plan (by paying a portion of the insurance premiums and a portion of the cost of medical care). But the amount that employees are responsible for varies greatly. Given the rising cost of health insurance, it’s important to understand the specific costs associated with a health care plan and to take these costs into account when comparing job offers. More important, it’s vital that you have medical insurance. Young people are often tempted to go without medical insurance, but this is a major mistake. An uncovered, costly medical emergency (say you’re rushed to the hospital with appendicitis) can be a financial disaster. You could end up paying for your hospital and doctor care for years.
• Disability insurance isn’t as well known as medical insurance, but it can be as important (if not more so). Disability insurance pays an income to an insured person when he or she is unable to work for an extended period. You would hope that you’d never need disability insurance, but if you did it would be of tremendous value.
• A flexible spending account allows a specified amount of pretax dollars to be used to pay for qualified expenses, including health care and child care. By paying for these costs with pretax dollars, employees are able to reduce their tax bill.
• There are two main types of retirement plans. One, called a defined benefit retirement plan, provides a set amount of money each month to retirees based on the number of years they worked and the income they earned. This form of retirement plan was once very popular, but it’s less common today. The other, called a defined contribution retirement plan, is a form of savings plan. The employee contributes money each pay period to his or her retirement account, and the employer matches a portion of the contribution. Even when retirement is exceedingly far into the future, it’s financially wise to set aside funds for retirement.
Key Takeaways
• Finance concerns the flow of money from one place to another; your personal finances concern your money and what you plan to do with it as it flows in and out of your possession. Personal finance is thus the application of financial principles to the monetary decisions that you make, either for your individual benefit or for that of your family.
• Financial planning is the ongoing process of managing your personal finances to meet goals that you’ve set for yourself or your family.
• The financial life cycle divides an individual’s life into three stages, each of which is characterized by different life events. Each stage also entails recommended changes in the focus of the individual’s financial planning:
1. In stage 1, the focus is on building wealth.
2. In stage 2, the focus shifts to the process of preserving and increasing the wealth that one has accumulated and continues to accumulate.
3. In stage 3, the focus turns to the process of living on (and, if possible, continuing to grow) one’s saved wealth.
• According to the model of the financial life cycle, financial planning begins in the individual’s early twenties, the age at which most people choose a career—both the sort of work they want to do during their income-generating years and the kind of lifestyle they want to live in the process.
• College is a good investment of both money and time. People who graduate from high school can expect to improve their average annual earnings by about 49 percent over those of people who don’t, and those who go on to finish college can expect to generate 82 percent more annual income than that. The area of study designated on your degree often doesn’t matter when you’re applying for a job: when poring over résumés, employers often look for the degree and simply note that a candidate has one.
• The first step in your job search is to prepare a résumé, a document that provides a summary of educational achievements and relevant job experience. Your résumé should be concise, clear, applicable to the job for which you are applying, and free of errors and inaccuracies.
• A cover letter is a document that accompanies your résumé and explains why you’re sending your résumé and highlights your qualifications.
• To conduct a general search for positions that might be of interest to you, you could:
1. Visit career Web sites, such as Monster.com, Wetfeet.com, or Careerbuilder.com.
2. Search classified ads in online and print newspapers.
3. Attend career fairs at your college and in your community.
4. Talk with recruiters when they visit your campus.
5. Contact people you know, tell them you’re looking for a job, and ask for their help.
• When you’re invited for an interview, you should research the company, practice answering questions you might be asked in the interview, and think up pertinent questions to ask the interviewer.
• When comparing job offers, consider more than salary. Also of importance are quality of life issues and benefits. Common financial benefits include health insurance, disability insurance, flexible spending accounts, and retirement plans.
1. Employer-sponsored health insurance plans vary greatly in coverage and cost to the employee.
2. Disability insurance pays an income to an insured person when he or she is unable to work for an extended period of time.
3. A flexible spending account allows a specified amount of pretax dollars to be used to pay for qualified expenses, including health care and child care. By paying for these costs with pretax dollars, employees are able to reduce their tax bill.
• There are two main types of retirement plans: a defined benefit plan, which provides a set amount of money each month to retirees based on the number of years they worked and the income they earned, and a defined contribution plan, which is a form of savings plan into which both the employee and employer contribute. A well-known defined contribution plan is a 401(k).
Exercise
(AACSB) Analysis
Think of the type of job you’d like to have. Describe the job and indicate how you’d go about getting a job offer for this type of job. How would you evaluate competing offers from two companies? What criteria would you use in selecting the right job for you?
Time Is Money
Learning Objectives
1. Explain compound interest and the time value of money.
2. Discuss the value of getting an early start on your plans for saving.
The fact that you have to choose a career at an early stage in your financial life cycle isn’t the only reason that you need to start early on your financial planning. Let’s assume, for instance, that it’s your eighteenth birthday and that on this day you take possession of \$10,000 that your grandparents put in trust for you. You could, of course, spend it; in particular, it would probably cover the cost of flight training for a private pilot’s license—something you’ve always wanted but were convinced that you couldn’t afford for another ten or fifteen years. Your grandfather, of course, suggests that you put it into some kind of savings account. If you just wait until you finish college, he says, and if you can find a savings plan that pays 5 percent interest, you’ll have the \$10,000 plus another \$2,209 to buy a pretty good used car.
The total amount you’ll have— \$12,209—piques your interest. If that \$10,000 could turn itself into \$12,209 after sitting around for four years, what would it be worth if you actually held on to it until you did retire—say, at age sixty-five? A quick trip to the Internet to find a compound-interest calculator informs you that, forty-seven years later, your \$10,000 will have grown to \$104,345 (assuming a 5 percent interest rate). That’s not really enough to retire on, but after all, you’d at least have some cash, even if you hadn’t saved another dime for nearly half a century. On the other hand, what if that four years in college had paid off the way you planned, so that (once you get a good job) you’re able to add, say, another \$10,000 to your retirement savings account every year until age sixty-five? At that rate, you’ll have amassed a nice little nest egg of slightly more than \$1.6 million.
Compound Interest
In your efforts to appreciate the potential of your \$10,000 to multiply itself, you have acquainted yourself with two of the most important concepts in finance. As we’ve already indicated, one is the principle of compound interest, which refers to the effect of earning interest on your interest.
Let’s say, for example, that you take your grandfather’s advice and invest your \$10,000 (your principal) in a savings account at an annual interest rate of 5 percent. Over the course of the first year, your investment will earn \$512 in interest and grow to \$10,512. If you now reinvest the entire \$10,512 at the same 5 percent annual rate, you’ll earn another \$537 in interest, giving you a total investment at the end of year 2 of \$11,049. And so forth. And that’s how you can end up with \$104,345 at age sixty-five.
Time Value of Money
You’ve also encountered the principle of the time value of money—the principle whereby a dollar received in the present is worth more than a dollar received in the future. If there’s one thing that we’ve stressed throughout this chapter so far, it’s the fact that, for better or for worse, most people prefer to consume now rather than in the future. This is true for both borrowers and lenders. If you borrow money from me, it’s because you can’t otherwise buy something that you want at the present time. If I lend it to you, it’s because I’m willing to postpone the opportunity to purchase something I want at the present time—perhaps a risk-free, ten-year U.S. Treasury bond with a present yield rate of 3 percent.
I’m willing to forego my opportunity, however, only if I can get some compensation for its loss, and that’s why I’m going to charge you interest. And you’re going to pay the interest because you need the money to buy what you want to buy. How much interest should we agree on? In theory, it could be just enough to cover the cost of my lost opportunity, but there are, of course, other factors. Inflation, for example, will have eroded the value of my money by the time I get it back from you. In addition, while I would be taking no risk in loaning money to the U.S. government (as I would be doing if I bought that Treasury bond), I am taking a risk in loaning it to you. Our agreed-on rate will reflect such factors.[36]
Finally, the time value of money principle also states that a dollar received today starts earning interest sooner than one received tomorrow. Let’s say, for example, that you receive \$2,000 in cash gifts when you graduate from college. At age twenty-three, with your college degree in hand, you get a decent job and don’t have an immediate need for that \$2,000. So you put it into an account that pays 10 percent compounded and you add another \$2,000 (\$167 per month) to your account every year for the next eleven years1. The left panel of Table 12.3 “Why to Start Saving Early (I)” shows how much your account will earn each year and how much money you’ll have at certain ages between twenty-three and sixty-seven. As you can see, you’d have nearly \$52,000 at age thirty-six and a little more than \$196,000 at age fifty; at age sixty-seven, you’d be just a bit short of \$1 million. The right panel of the same table shows what you’d have if you hadn’t started saving \$2,000 a year until you were age thirty-six. As you can also see, you’d have a respectable sum at age sixty-seven—but less than half of what you would have accumulated by starting at age twenty-three. More important, even to accumulate that much, you’d have to add \$2,000 per year for a total of thirty-two years, not just twelve.
Table 12.3 Why to Start Saving Early (I)[37]
Savings accumulated from age 23, with deposits of \$2,000 annually until age 67 Savings accumulated from age 36, with deposits of \$2,000 annually until age 67
Age Annual deposit Annual interest earned Total saved at the end of the year Annual deposit Annual interest earned Total saved at the end of the year
23 \$0.00 \$0.00 \$0.00 \$0.00 \$0.00 \$0.00
24 \$2,000 \$200.00 \$2,200 \$0.00 \$0.00 \$0.00
25 \$2,000 \$420.00 \$4,620 \$0.00 \$0.00 \$0.00
30 \$2,000 \$1,897.43 \$20,871.78 \$0.00 \$0.00 \$0.00
35 \$2,000 \$4,276.86 \$47,045.42 \$0.00 \$0.00 \$0.00
36 \$0.00 \$4,704.54 \$51,749.97 \$2,000 \$200.00 \$2,200.00
40 \$0.00 \$6,887.92 \$75,767.13 \$2,000 \$1,221.02 \$13,431.22
45 \$0.00 \$11,093.06 \$122,023.71 \$2,000 \$3,187.48 \$35,062.33
50 \$0.00 \$17,865.49 \$196,520.41 \$2,000 \$6,354.50 \$69,899.46
55 \$0.00 \$28,772.55 \$316,498.09 \$2,000 \$11,455.00 \$126,005.00
60 \$0.00 \$46,338.49 \$509,723.34 \$2,000 \$19,669.41 \$216,363.53
65 \$0.00 \$74,628.59 \$820,914.53 \$2,000 \$32,898.80 \$361,886.65
67 \$0.00 \$90,300.60 \$993,306.53 \$2,000 \$40,277.55 \$442,503.09
Here’s another way of looking at the same principle. Suppose that you’re twenty years old, don’t have \$2,000, and don’t want to attend college full-time. You are, however, a hard worker and a conscientious saver, and one of your (very general) financial goals is to accumulate a \$1 million retirement nest egg. As a matter of fact, if you can put \$33 a month into an account that pays 12 percent interest compounded[38], you can have your \$1 million by age sixty-seven. That is, if you start at age twenty. As you can see from Table 12.4 “Why to Start Saving Early (II)”, if you wait until you’re twenty-one to start saving, you’ll need \$37 a month. If you wait until you’re thirty, you’ll have to save \$109 a month, and if you procrastinate until you’re forty, the ante goes up to \$366 a month.[39]
Table 12.4 Why to Start Saving Early (II)[40]
First Payment When You Turn Required Monthly Payment First Payment When You Turn Required Monthly Payment
20 \$33 30 \$109
21 \$37 31 \$123
22 \$42 32 \$138
23 \$47 33 \$156
24 \$53 34 \$176
25 \$60 35 \$199
26 \$67 40 \$366
27 \$76 50 \$1,319
28 \$85 60 \$6,253
29 \$96
The moral here should be fairly obvious: a dollar saved today not only starts earning interest sooner than one saved tomorrow (or ten years from now) but also can ultimately earn a lot more money in the long run. Starting early means in your twenties—early in stage 1 of your financial life cycle. As one well-known financial advisor puts it, “If you’re in your 20s and you haven’t yet learned how to delay gratification, your life is likely to be a constant financial struggle”.[41]
Key Takeaways
• The principle of compound interest refers to the effect of earning interest on your interest.
• The principle of the time value of money is the principle whereby a dollar received in the present is worth more than a dollar received in the future.
• The principle of the time value of money also states that a dollar received today starts earning interest sooner than one received tomorrow.
• Together, these two principles give a significant financial advantage to individuals who begin saving early during the financial-planning life cycle.
Exercise
(AACSB) Analysis
Everyone wants to be a millionaire (except those who are already billionaires). To find out how old you’ll be when you become a millionaire, go to http://www.youngmoney.com/calculators/savings_calculators/millionaire_calculator and input these assumptions:
Age: your actual age
Amount currently invested: \$10,000
Expected rate of return (interest rate): 5 percent
Millionaire target age: 65
Savings per month: \$500
Expected inflation rate: 3 percent
Click “calculate” and you’ll learn when you’ll become a millionaire (given the previous assumptions).
Now, let’s change things. We’ll go through this process three times. Change only the items described. Keep all other assumptions the same as those listed previously.
1. Change the interest rate to 3 percent and then to 6 percent.
2. Change the savings amount to \$200 and then to \$800.
3. Change your age from “your age” to “your age plus 5” and then to “your age minus 5.”
Write a brief report describing the sensitivity of becoming a millionaire, based on changing interest rates, monthly savings amount, and age at which you begin to invest.
The Financial Planning Process
Learning Objectives
1. Identify the three stages of the personal-finances planning process.
2. Explain how to draw up a personal net-worth statement, a personal cash-flow statement, and a personal budget.
We’ve divided the financial planning process into three steps:
1. Evaluate your current financial status by creating a net worth statement and a cash flow analysis.
2. Set short-term, intermediate-term, and long-term financial goals.
3. Use a budget to plan your future cash inflows and outflows and to assess your financial performance by comparing budgeted figures with actual amounts.
Step 1: Evaluating Your Current Financial Situation
Just how are you doing, financially speaking? You should ask yourself this question every now and then, and it should certainly be your starting point when you decide to initiate a more or less formal financial plan. The first step in addressing this question is collecting and analyzing the records of what you own and what you owe and then applying a few accounting terms to the results:
• Your personal assets consist of what you own.
• Your personal liabilities are what you owe—your obligations to various creditors, big and small.
Preparing Your Net-Worth Statement
Your net worth (accounting term for your wealth) is the difference between your assets and your liabilities. Thus the formula for determining net worth is:
Assets − Liabilities = Net worth
If you own more than you owe, your net worth will be positive; if you owe more than you own, it will be negative. To find out whether your net worth is on the plus or minus side, you can prepare a personal net worth statement like the one in Figure 12.6 “Net Worth Statement”, which we’ve drawn up for a fictional student named Joe College (Note that we’ve included lines for items that may be relevant to some people’s net worth statements but left them blank when they don’t apply to Joe).
Assets
Joe has two types of assets:
• First are his monetary or liquid assets—his cash, the money in his checking accounts, and the value of any savings, CDs, and money market accounts. They’re called liquid because either they’re cash or they can readily be turned into cash.
• Everything else is a tangible asset—something that Joe can use, as opposed to an investment. (We haven’t given Joe any investments—such financial assets as stocks, bonds, or mutual funds—because people usually purchase these instruments to meet such long-term goals as buying a house or sending a child to college.)
Note that we’ve been careful to calculate Joe’s assets in terms of their fair market value—the price he could get by selling them at present, not the price he paid for them or the price that he could get at some future time.
Liabilities
Joe’s net worth statement also divides his liabilities into two categories:
• Anything that Joe owes on such items as his furniture and computer are current liabilities—debts that must be paid within one year. Much of this indebtedness no doubt ends up on Joe’s credit card balance, which is regarded as a current liability because he should pay it off within a year.
• By contrast, his car payments and student-loan payments are noncurrent liabilities—debt payments that extend for a period of more than one year. Joe is in no position to buy a house, but for most people, their mortgage is their most significant noncurrent liability.
Finally, note that Joe has positive net worth. At this point in the life of the average college student, positive net worth may be a little unusual. If you happen to have negative net worth right now, you’re technically insolvent, but remember that a major goal of getting a college degree is to enter the workforce with the best possible opportunity for generating enough wealth to reverse that situation.
Preparing Your Cash-Flow Statement
Now that you know something about your financial status on a given date, you need to know more about it over a period of time. This is the function of a cash-flow or income statement, which shows where your money has come from and where it’s slated to go.
Figure 12.7 “Cash-Flow Statement” is Joe College’s cash-flow statement. As you can see, Joe’s income (his cash inflows—money coming in) is derived from two sources: student loans and income from a part-time job. His expenditures (cash outflows—money going out) fall into several categories: housing, food, transportation, personal and health care, recreation/entertainment, education, insurance, savings, and other expenses. To find out Joe’s net cash flow, we subtract his expenditures from his income:
\$25,700 – \$25,300 = \$400
Figure 12.7 Cash-Flow Statement
Joe has been able to maintain a positive cash flow for the year ending August 31, 2012, but he’s cutting it close. Moreover, he’s in the black only because of the inflow from student loans—income that, as you’ll recall from his net worth statement, is also a noncurrent liability. We are, however, willing to give Joe the benefit of the doubt: Though he’s incurring the high costs of an education, he’s willing to commit himself to the debt (and, we’ll assume, to careful spending) because he regards education as an investment that will pay off in the future.
Remember that when constructing a cash-flow statement, you must record only income and expenditures that pertain to a given period, whether it be a month, a semester, or (as in Joe’s case) a year. Remember, too, that you must figure both inflows and outflows on a cash basis: you record income only when you receive money, and you record expenditures only when you pay out money. When, for example, Joe used his credit card to purchase his computer, he didn’t actually pay out any money. Each monthly payment on his credit card balance, however, is an outflow that must be recorded on his cash-flow statement (according to the type of expense—say, recreation/entertainment, food, transportation, and so on).
Your cash-flow statement, then, provides another perspective on your solvency: if you’re insolvent, it’s because you’re spending more than you’re earning. Ultimately, your net worth and cash-flow statements are most valuable when you use them together. While your net worth statement lets you know what you’re worth—how much wealth you have—your cash-flow statement lets you know precisely what effect your spending and saving habits are having on your wealth.
Step 2: Set Short-Term, Intermediate-Term, and Long-Term Financial Goals
We know from Joe’s cash-flow statement that, despite his limited income, he feels that he can save \$1,200 a year. He knows, of course, that it makes sense to have some cash in reserve in case of emergencies (car repairs, medical needs, and so forth), but he also knows that by putting away some of his money (probably each week), he’s developing a habit that he’ll need if he hopes to reach his long-term financial goals.
Just what are Joe’s goals? We’ve summarized them in Figure 12.8 “Joe’s Goals”, where, as you can see, we’ve divided them into three time frames: short-term (less than two years), intermediate-term (two to five years), and long-term (more than five years). Though Joe is still in an early stage of his financial life cycle, he has identified and structured his goals fairly effectively. In particular, they satisfy four criteria of well-conceived goals: they’re realistic and measurable, and Joe has designated both definite time frames and specific courses of action.[42]
Figure 12.8 Joe’s Goals
Short-term goals
(less than 2 years)
Intermediate-term goals
(2-5 years)
Long-term goals
(more than 5 years)
• Pay off car loan
• Pay off credit card and charge account debt
• Complete college
• Take one-month vacation after completing college
• Pay off student loans
• Buy a home
• Save for retirement
They’re also sensible. Joe sees no reason, for example, why he can’t pay off his car loan, credit card, and charge account balances within two years. Remember that, with no income other than student-loan money and wages from a part-time job, Joe has decided (rightly or wrongly) to use his credit cards to pay for much of his personal consumption (furniture, electronics equipment, and so forth). It won’t be an easy task to pay down these balances, so we’ll give him some credit (so to speak) for regarding them as important enough to include paying them among his short-term goals. After finishing college, he’ll splurge and take a month-long vacation. This might not be the best thing to do from a financial point of view, but he knows this could be his only opportunity to travel extensively. He is realistic in his classification of student loan repayment and the purchase of a home as long-term. But he might want to revisit his decision to classify saving for his retirement as a long-term goal. This is something we believe he should begin as soon as he starts working full-time.
Step 3: Develop a Budget and Use It to Evaluate Financial Performance
Once he has reviewed his cash-flow statement, Joe has a much better idea of what cash flowed in for the year that ended August 31, 2012, and a much better idea of where it went when it flowed out. Now he can ask himself whether he’s satisfied with his annual inflow (income) and outflow (expenditures). If he’s anything like most people, he’ll want to make some changes—perhaps to increase his income, to cut back on his expenditures, or, if possible, both. The first step in making these changes is drawing up a personal budget—a document that itemizes the sources of his income and expenditures for the coming year, along with the relevant money amounts for each.
Having reviewed the figures on his cash-flow statement, Joe did in fact make a few decisions:
• Because he doesn’t want to jeopardize his grades by increasing his work hours, he’ll have to reconcile himself to just about the same wages for another year.
• He’ll need to apply for another \$7,000 student loan.
• If he’s willing to cut his spending by \$1,200, he can pay off his credit cards. Toward this end, he’s targeted the following expenditures for reduction: rent (get a cheaper apartment), phone costs (switch plans), auto insurance (take advantage of a “good-student” discount), and gasoline (pool rides or do a little more walking). Fortunately, his car loan will be paid off by midyear.
Revising his figures accordingly, Joe developed the budget in Figure 12.9 “Joe’s Budget” for the year ending August 31, 2013. Look first at the column headed “Budget.” If things go as planned, Joe expects a cash surplus of \$1,600 by the end of the year—enough to pay off his credit card debt and leave him with an extra \$400.
Figure 12.9 Joe’s Budget
Figuring the Variance
Now we can examine the two remaining columns in Joe’s budget. Throughout the year, Joe will keep track of his actual income and actual expenditures and will enter the totals in the column labeled “Actual.” Like most reasonable people, however, Joe doesn’t really expect his actual figures to match with his budgeted figures. So whenever there’s a difference between an amount in his “Budget” column and the corresponding amount in his “Actual” column, Joe records the difference, whether plus or minus, as a variance. Two types of variances appear in Joe’s budget:
• Income variance. When actual income turns out to be higher than expected or budgeted income, Joe records the variance as “favorable.” (This makes sense, as you’d find it favorable if you earned more income than expected.) When it’s just the opposite, he records the variance as “unfavorable.”
• Expense variance. When the actual amount of an expenditure is more than he had budgeted for, he records it as an “unfavorable” variance. (This also makes sense, as you’d find it unfavorable if you spent more than the budgeted amount.) When the actual amount is less than budgeted, he records it as a “favorable” variance.
Setting Mature Goals
Before we leave the subject of the financial-planning process, let’s revisit the topic of Joe’s goals. Another look at Figure 12.8 “Joe’s Goals” reminds us that, at the current stage of his financial life cycle, Joe has set fairly simple goals. We know, for example, that Joe wants to buy a home, but when does he want to take this major financial step? And of course, Joe wants to retire, but what kind of lifestyle does he want in retirement? Does he expect, like most people, a retirement lifestyle that’s more or less comparable to that of his peak earning years? Will he be able to afford both the cost of a comfortable retirement and, say, the cost of sending his children to college? As Joe and his financial circumstances mature, he’ll have to express these goals (and a few others) in more specific terms.
Levels of Mature Goals
Let’s fast-forward a decade or so, when Joe’s picture of stages 2 and 3 of his financial life cycle have come into clearer focus. If he hasn’t done so already, Joe is now ready to identify a primary goal to guide him in identifying and meeting all his other goals.[43] Suppose that because Joe’s investment in a college education has paid off the way he’d planned ten years ago, he’s in a position to target a primary goal of financial independence—by which he means a certain financially secure life not only for himself but for his children, as well. Now that he’s set this primary goal, he can identify a more specific set of goals—say, the following:
• A standard of living that reflects a certain level of comfort—a level associated with the possession of certain assets, both tangible and intangible.
• The ability to provide his children with college educations.
• A retirement lifestyle comparable to that of his peak earning years.
Having set this secondary level of goals, Joe’s now ready to make specific plans for reaching them. As we’ve already seen, Joe understands that plans are far more likely to work out when they’re focused on specific goals. His next step, therefore, is to determine the goals on which he should focus this next level of plans.
As it turns out, Joe already knows what these goals are, because he’s been setting the appropriate goals every year since he drew up the cash-flow statement in Figure 12.7 “Cash-Flow Statement”. In drawing up that statement, Joe was careful to create several line items to identify his various expenditures: housing, food, transportation, personal and health care, recreation/entertainment, education, insurance, savings, and other expenses. When we introduced these items, we pointed out that each one represents a cash outflow—something for which Joe expected to pay. They are, in other words, things that Joe intends to buy or, in the language of economics, consume. As such, we can characterize them as consumption goals. These “purchases”—what Joe wants in such areas as housing, insurance coverage, recreation/entertainment, and so forth—make specific his secondary goals and are therefore his third-level goals.
Figure 12.10 “Three-Level Goals/Plans” gives us a full picture of Joe’s three-level hierarchy of goals.
Figure 12.10 Three-Level Goals/Plans
Present and Future Consumption Goals
A closer look at the list of Joe’s consumption goals reveals that they fall into two categories:
1. We can call the first category present goals because each item is intended to meet Joe’s present needs and those (we’ll now assume) of his family—housing, health care coverage, and so forth. They must be paid for as Joe and his family take possession of them—that is, when they use or consume them. All these things are also necessary to meet the first of Joe’s secondary goals—a certain standard of living.
2. The items in the second category of Joe’s consumption goals are aimed at meeting his other two secondary goals: sending his children to college and retiring with a comfortable lifestyle. He won’t take possession of these purchases until sometime in the future, but (as is so often the case) there’s a catch: they must be paid for out of current income.
A Few Words about Saving
Joe’s desire to meet this second category of consumption goals—future goals such as education for his kids and a comfortable retirement for himself and his wife—accounts for the appearance on his list of the one item that, at first glance, may seem misclassified among all the others: namely, savings.
Paying Yourself First
It’s tempting to glance at Joe’s budget and cash-flow statement and assume that he shares with most of us a common attitude toward saving money: when you’re done allotting money for various spending needs, you can decide what to do with what’s left over—save it or spend it. In reality, however, Joe’s budgeting reflects an entirely different approach. When he made up the budget in Figure 12.9 “Joe’s Budget”, Joe started out with the decision to save \$1,600—or at least to avoid spending it. Why? Because he had a goal: to be free of credit card debt. To meet this goal, he planned to use \$1,200 of his current income to pay off what would continue to hang over his head as a future expense (his credit card debt). In addition, he planned to have \$400 left over after he’d paid his credit card balance. Why? Because he had still longer-term goals, and he intended to get started on them early—as soon as he finished college. Thus his intention from the outset was to put \$400 into savings.
In other words, here’s how Joe went about budgeting his money for the year ending August 31, 2013 (as shown in Figure 12.9 “Joe’s Budget”):
1. He calculated his income—total cash inflows from his student loan and his part-time job (\$25,700).
2. He subtracted from his total income two targeted consumption goals—credit card payments (\$1,200) and savings (\$400).
3. He allocated what was left (\$24,100) to his remaining consumption goals: housing (\$6,600), food (\$3,500), education (\$6,500), and so forth.
If you’re concerned that Joe’s sense of delayed gratification is considerably more mature than your own, think of it this way: Joe has chosen to pay himself first. It’s one of the key principles of personal-finances planning and an important strategy in doing something that we recommended earlier in this chapter—starting early.[44]
Key Takeaways
• The financial planning process consists of three steps:
1. Evaluate your current financial status by creating a net worth statement and a cash flow analysis.
2. Set short-term, intermediate-term, and long-term financial goals.
3. Use a budget to plan your future cash inflows and outflows and to assess your financial performance by comparing budgeted figures with actual amounts.
• In step 1 of the financial planning process, you determine what you own and what you owe:
1. Your personal assets consist of what you own.
2. Your personal liabilities are what you owe—your obligations to various creditors.
• Most people have two types of assets:
1. Monetary or liquid assets include cash, money in checking accounts, and the value of any savings, CDs, and money market accounts. They’re called liquid because either they’re cash or they can readily be turned into cash.
2. Everything else is a tangible asset—something that can be used, as opposed to an investment.
• Likewise, most people have two types of liabilities:
1. Any debts that should be paid within one year are current liabilities.
2. Noncurrent liabilities consist of debt payments that extend for a period of more than one year.
• Your net worth is the difference between your assets and your liabilities. Your net worth statement will show whether your net worth is on the plus or minus side on a given date.
• In step 2 of the financial planning process, you create a cash-flow or income statement, which shows where your money has come from and where it’s slated to go. It reflects your financial status over a period of time. Your cash inflows—the money you have coming in—are recorded as income. Your cash outflows—money going out—are itemized as expenditures in such categories as housing, food, transportation, education, and savings.
• A good way to approach your financial goals is by dividing them into three time frames: short-term (less than two years), intermediate-term (two to five years), and long-term (more than five years). Goals should be realistic and measurable, and you should designate definite time frames and specific courses of action.
• Net worth and cash-flow statements are most valuable when used together: while your net worth statement lets you know what you’re worth, your cash-flow statement lets you know precisely what effect your spending and saving habits are having on your net worth.
• If you’re not satisfied with the effect of your spending and saving habits on your net worth, you may want to make changes in future inflows (income) and outflows (expenditures). You make these changes in step 3 of the financial planning process, when you draw up your personal budget—a document that itemizes the sources of your income and expenditures for a future period (often a year).
• In addition to the itemized lists of inflows and outflows, there are three other columns in the budget:
1. The “Budget” column tracks the amounts of money that you plan to receive or to pay out over the budget period.
2. The “Actual” column records the amounts that did in fact come in or go out.
3. The final column records the variance for each item—the difference between the amount in the “Budget” column and the corresponding amount in the “Actual” column.
• There are two types of variance:
1. An income variance occurs when actual income is higher than budgeted income (or vice versa).
2. An expense variance occurs when the actual amount of an expenditure is higher than the budgeted amount (or vice versa).
Exercise
(AACSB) Analysis
Using your own information (or made-up information if you prefer), go through the three steps in the financial planning process:
1. Evaluate your current financial status by creating a net worth statement and a cash flow analysis.
2. Identify short-term, intermediate-term, and long-term financial goals.
3. Create a budget (for a month or a year). Estimate future income and expenditures. Make up “actual” figures and calculate a variance by comparing budgeted figures with actual amounts.
A House Is Not a Piggy Bank: A Few Lessons from the Subprime Crisis
Learning Objectives
1. Discuss the trend in the U.S. savings rate.
2. Define a subprime loan and explain the difference between a fixed-rate mortgage and an adjustable-rate mortgage.
3. Discuss what can go wrong with a subprime loan at an adjustable rate. Discuss what can go wrong with hundreds of thousands of subprime loans at adjustable rates.
4. Define risk and explain some of the risks entailed by personal financial transactions.
Joe isn’t old enough to qualify, but if his grandfather had deposited \$1,000 in an account paying 7 percent interest in 1945, it would now be worth \$64,000. That’s because money invested at 7 percent compounded will double every ten years. Now, \$64,000 may or may not seem like a significant return over fifty years, but after all, the money did all the heavy lifting, and given the miracle of compound interest, it’s surprising that Americans don’t take greater advantage of the opportunity to multiply their wealth by saving more of it, even in modest, interest-bearing accounts. Ironically, with \$790 billion in credit card debt, it’s obvious that a lot of American families are experiencing the effects of compound interest—but in reverse.[45]
As a matter of fact, though Joe College appears to be on the right track when it comes to saving, many people aren’t. A lot of Americans, it seems, do indeed set savings goals, but in one recent survey, nearly 70 percent of the respondents reported that they fell short of their monthly goals because their money was needed elsewhere. About one-third of Americans say that they’re putting away something but not enough, and another third aren’t saving anything at all. Almost one-fifth of all Americans have net worth of zero—or less.[46][47]
As we indicated in the opening section of this chapter, this shortage of savings goes hand in hand with a surplus in spending. “My parents,” says one otherwise gainfully employed American knowledge worker, “are appalled at the way I justify my spending. I think, ‘Why work and make money unless you’re going to enjoy it?’ That’s a fine theory,” she adds, “until you’re sixty, homeless, and with no money in the bank”.[48] And indeed, if she doesn’t intend to alter her personal-finances philosophy, she has good reason to worry about her “older adult” years. Sixty percent of Americans over the age of sixty-five have less than \$100,000 in savings, and only 30 percent of this group have more than \$25,000; 45 percent have less than \$15,000. As for income, 75 percent of people over age sixty-five generate less than \$35,000 annually, and 30 percent are in the “poverty to near-poverty” range of \$10,000 to \$20,000 (as compared to 12 percent of the under-sixty-five population).[49]
Disposing of Savings
Figure 12.11 “U.S. Savings Rate” shows the U.S. savings rate—which measures the percentage of disposable income devoted to savings for the period 1960 to 2010. As you can see, it suffered a steep decline from 1980 to 2005 and remained at this negligible savings rate until it started moving up in 2008. The recent increase in the savings rate, however, is still below the long-term average of 7 percent.[50][51]
Figure 12.11 U.S. Savings Rate
Now, a widespread tendency on the part of Americans to spend rather than save doesn’t account entirely for the downward shift in the savings rate. In late 2005, the Federal Reserve cited at least two other (closely related) factors in the decline of savings:[52]
• An increase in the ratio of stock-market wealth to disposable income
• An increase in the ratio of residential-property wealth to disposable income
Assume, for example, that, in addition to your personal savings, you own some stock and have a mortgage on a home. Both your stock and your home are (supposedly) appreciable assets—their value used to go up over time. (In fact, if you had taken out your mortgage in 2000, by the end of 2005 your home would have appreciated at double the rate of your disposable personal income.) The decline in the personal savings rate during the mid-2000s, suggested the Fed, resulted in part from people’s response to “long-lived bull markets in stocks and housing”; in other words, a lot of people had come to rely on the appreciation of such assets as stocks and residential property as “a substitute for the practice of saving out of wage income.”
Subprime Rates and Adjustable Rate Mortgages
Let’s assume that you weren’t ready to take advantage of the boom in mortgage loans in 2000 but did set your sights on 2005. You may not have been ready to buy a house in 2005 either, but there’s a good chance that you got a loan anyway. In particular, some lender might have offered you a so-called subprime mortgage loan. Subprime loans are made to borrowers who don’t qualify for market-set interest rates because of one or more risk factors—income level, employment status, credit history, ability to make only a very low down payment. As of March 2007, U.S. lenders had written \$1.3 trillion in mortgages like yours.[53]
Granted, your terms might not have been very good. For one thing, interest rates on subprime loans may run from 8 percent to 10 percent and higher.[54] In addition, you probably had to settle for an adjustable-rate mortgage (ARM)—one that’s pegged to the increase or decrease of certain interest rates that your lender has to pay. When you signed your mortgage papers, you knew that if those rates went up, your mortgage rate—and your monthly payments—would go up, too. Fortunately, however, you had a plan B: with the value of your new asset appreciating even as you enjoyed living in it, it wouldn’t be long before you could refinance it at a more manageable and more predictable rate.
The Meltdown
Now imagine your dismay when housing prices started to go down in 2006 and 2007. As a result, you weren’t able to refinance, your ARM was set to adjust upward in 2008, and foreclosures were already happening all around you—1.3 million in 2007 alone.[55] By April 2008, one in every 519 American households had received a foreclosure notice.[56] By August, 9.2 percent of the \$12 trillion in U.S. mortgage loans was delinquent or in foreclosure.[57][58]
Figure 12.12 Foreclosure
In 2008, nearly one out of five hundred households in the United States received a foreclosure notice.[59]
The repercussions? Banks and other institutions that made mortgage loans were the first sector of the financial industry to be hit. Largely because of mortgage-loan defaults, profits at more than 8,500 U.S. banks dropped from \$35 billion in the fourth quarter of 2006 to \$650 million in the corresponding quarter of 2007 (a decrease of 89 percent). Bank earnings for the year 2007 declined 31 percent and dropped another 46 percent in the first quarter of 2008.[60][61]
Losses in this sector were soon felt by two publicly traded government-sponsored organizations, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both of these institutions are authorized to make loans and provide loan guarantees to banks, mortgage companies, and other mortgage lenders; their function is to make sure that these lenders have enough money to lend to prospective home buyers. Between them, Fannie Mae and Freddie Mac backed approximately half of that \$12 trillion in outstanding mortgage loans, and when the mortgage crisis hit, the stock prices of the two corporations began to drop steadily. In September 2008, amid fears that both organizations would run out of capital, the U.S. government took over their management.
Freddie Mac also had another function: to increase the supply of money available for mortgage loans and new home purchases, Freddie Mac bought mortgages already written by lenders, pooled them, and sold them as mortgage-backed securities to investors on the open market. Many major investment firms did much the same thing, buying individual subprime mortgages from original lenders (such as small banks), pooling the projected revenue—payments made by the original individual home buyers—and selling securities backed by the pooled revenue.
But when their rates went too high and home buyers couldn’t make these payments, these securities plummeted in value. Institutions that had invested in them—including investment banks—suffered significant losses.[62] In September 2008, one of these investment banks, Lehman Brothers, filed for bankruptcy protection; another, Merrill Lynch, agreed to sell itself for \$50 billion. Next came American International Group (AIG), a giant insurance company that insured financial institutions against the risks they took in loaning and investing money. As its policyholders buckled under the weight of defaulted loans and failed investments, AIG, too, was on the brink of bankruptcy, and when private efforts to bail it out failed, the U.S. government stepped in with a loan of \$85 billion.[63] The U.S. government also agreed to buy up risky mortgage-backed securities from teetering financial institutions at an estimated cost of “hundreds of billions”.[64]
Subprime Directives: A Few Lessons from the Subprime Crisis
If you were one of the millions of Americans who took out subprime mortgages in the years between 2001 and 2005, you probably have some pressing financial problems. If you defaulted on your subprime ARM, you may have suffered foreclosure on your newly acquired asset, lost any equity that you’d built up in it, and taken a hit in your credit rating. (We’ll assume that you’re not one of the people whose eagerness to get on the subprime bandwagon caused fraudulent mortgage applications to go up by 300 percent between 2002 and 2006.)[65]
On the other hand, you’ve probably learned a few lessons about financial planning and strategy. Let’s conclude with a survey of three lessons that you should have learned from your hypothetical adventure in the world of subprime mortgages.
Lesson 1: All mortgages are not created equal. Despite (or perhaps because of) the understandable enticement of home ownership, your judgment may have been faulty in this episode of your financial life cycle. Generally speaking, you’re better off with a fixed-rate mortgage—one on which the interest rate remains the same regardless of changes in market interest rates—than with an ARM.[66] As we’ve explained at length in this chapter, planning is one of the cornerstones of personal-finances management, and ARMs don’t lend themselves to planning. How well can you plan for your future mortgage payments if you can’t be sure what they’re going to be?
In addition, though interest rates may go up or down, planning for them to go down and to take your mortgage payments with them doesn’t make much sense. You can wait around to get lucky, and you can even try to get lucky (say, by buying a lottery ticket), but you certainly can’t plan to get lucky. Unfortunately, the only thing you can really plan for is higher rates and higher payments. An ARM isn’t a good idea if you don’t know whether you can meet payments higher than your initial payment. In fact, if you have reason to believe that you can’t meet the maximum payment entailed by an ARM, you probably shouldn’t take it on.
Lesson 2: It’s risky out there. You now know—if you hadn’t suspected it already—that planning your personal finances would be a lot easier if you could do it in a predictable economic environment. But you can’t, of course, and virtually constant instability in financial markets is simply one economic fact of life that you’ll have to deal with as you make your way through the stages of your financial life cycle.
In other words, any foray into financial markets is risky. Basically, risk is the possibility that cash flows will be variable.[67] Unfortunately, volatility in the overall economy is directly related to just one category of risks. There’s a second category—risks related to the activities of various organizations involved in your financial transactions. You’ve already been introduced to the effects of these forms of financial risk, some of which have affected you directly, some of which have affected you indirectly, and some of which may affect you in the future:[68]
• Management risk is the risk that poor management of an organization with which you’re dealing may adversely affect the outcome of your personal-finances planning. If you couldn’t pay the higher rate on your ARM, managers at your lender probably failed to look deeply enough into your employment status and income.
• Business risk is the risk associated with a product that you’ve chosen to buy. The fate of your mortgagor, who issued the original product—your subprime ARM—and that of everyone down the line who purchased it in some form (perhaps Freddy Mac and Merrill Lynch) bear witness to the pitfalls of business risk.
• Financial risk refers to the risk that comes from ill-considered indebtedness. Freddie Mac, Fannie Mae, and several investment banks have felt the repercussions of investing too much money in financial instruments that were backed with shaky assets (namely, subprime mortgages).
In your own small way, of course, you, too, underestimated the pitfalls of all three of these forms of risk.
Lesson 3: Not all income is equally disposable. Figure 12.13 “Debt-Income Ratio” shows the increase in the ratio of debt to disposable income among American households between 1985 and 2007. As you can see, the increase was dramatic—from 80 percent in the early 1990s to about 130 percent in 2007.[69] This rise was made possible by greater access to credit—people borrow money in order to spend it, whether on consumption or on investments, and the more they can borrow, the more they can spend.
In the United States, greater access to credit in the late 1990s and early 2000s was made possible by rising housing prices: the more valuable your biggest asset, the more lenders are willing to lend you, even if what you’re buying with your loan—your house—is your biggest asset. As the borrower, your strategy is twofold: (1) Pay your mortgage out of your wage income, and (2) reap the financial benefits of an asset that appreciates in value. On top of everything else, you can count the increased value of your asset as savings: when you sell the house at retirement, the difference between your mortgage and the current value of your house is yours to support you in your golden years.
Figure 12.13 Debt-Income Ratio
As we know, however, housing prices had started to fall by the end of 2006. From a peak in mid-2006, they had fallen 8 percent by November 2007, and by April 2008 they were down from the 2006 peak by more than 19 percent—the worst rate of decline since the Great Depression. And most experts expected it to get worse before it gets better, and unfortunately they were right. Housing prices have declined by 33 percent from the mid-2006 peak to the end of 2010.[70][71]
So where do you stand? As you know, your house is worth no more than what you can get for it on the open market; thus the asset that you were counting on to help provide for your retirement has depreciated substantially in little more than a decade. If you’re one of the many Americans who tried to substitute equity in property for traditional forms of income savings, one financial specialist explains the unfortunate results pretty bluntly: your house “is a place to live, not a brokerage account”.[72] If it’s any consolation, you’re not alone: a recent study by the Security Industries Association reports that, for many Americans, nearly half their net worth is based on the value of their home. Analysts fear that many of these people—a significant proportion of the baby-boom generation—won’t be able to retire with the same standard of living that they’ve been enjoying during their wage-earning years.[73]
Key Takeaways
• Personal saving suffered a steep decline from 1980 to 2005 and remained at this negligible savings rate until it started moving up in 2008. The recent increase in the savings rate, however, is still below the long-term average of 7 percent.
• In addition to Americans’ tendency to spend rather than save, the Federal Reserve observed that a lot of people had come to rely on the appreciation of such assets as stocks and residential property as a substitute for the practice of saving out of wage income.
• Subprime loans are made to would-be home buyers who don’t qualify for market-set interest rates because of one or more risk factors—income level, employment status, credit history, ability to make only a very low down payment. Interest rates may run from 8 percent to 10 percent and higher.
• An adjustable-rate mortgage (ARM) is a home loan pegged to the increase or decrease of certain interest rates that the lender has to pay. If those rates go up, the mortgage rate and the home buyer’s monthly payments go up, too. A fixed-rate mortgage is a home loan on which the interest rate remains the same regardless of changes in market interest rates.
• In the years between 2001 and 2005, lenders made billions of dollars in subprime ARM loans to American home buyers. In 2006 and 2007, however, housing prices started to go down. Homeowners with subprime ARM loans weren’t able to refinance, their mortgage rates began going up, and foreclosures became commonplace.
• In 2006 and 2007, largely because of mortgage-loan defaults, banks and other institutions that made mortgage loans began losing huge sums of money. These losses carried over to Fannie Mae and Freddie Mac, publicly traded government-sponsored organizations that make loans and provide loan guarantees to banks and other mortgage lenders.
• Next to be hit were major investment firms that had been buying subprime mortgages from banks and other original lenders, pooling the projected revenue—payments made by the original individual home buyers—and selling securities backed by the pooled revenue. When their rates went too high and home buyers couldn’t make their house payments, these securities plummeted in value, and the investment banks and other institutions that had invested in them suffered significant losses.
• Risk is the possibility that cash flows will be variable. Three types of risk are related to the activities of various organizations that may be involved in your financial transactions:
1. Management risk is the risk that poor management of an organization with which you’re dealing may adversely affect the outcome of your personal-finances planning.
2. Business risk is the risk associated with a product that you’ve chosen to buy.
3. Financial risk refers to the risk that comes from ill-considered indebtedness.
Exercise
(AACSB) Analysis
Write a report giving your opinion on how we got into the subprime mortgage crisis and how we’ll get out of it
Cases and Problems
Learning on the Web (AACSB)
Go to https://www.quizzle.com and request a free copy of your credit report. Review the report. If you identify any errors, get them fixed. Write a brief report explaining the value of good credit.
Ethics Angle (AACSB)
Go online and read this article at Forbes.com: “Most Common Resume Lies,” by Kate DuBose Tomassi at http://www.forbes.com/workspecial/2006/05/20/resume-lies-work_cx_kdt_06work_0523lies.html. View the slide show of common résumé lies. Answer these questions: What are the most common lies made in résumés? Why is it a bad idea to lie on such a document? What are the potential consequences of misstating facts on your résumé?
Team-Building Skills (AACSB)
It’s becoming more difficult for individuals to buy homes. This has meant that many people who would have bought a home have remained in apartments. In big cities, such as New York, sharing an apartment with roommates is a good way to save money. Yet it has some disadvantages. Get together as a team and identify the pros and cons of sharing housing. Pretend that each member of the group has agreed to share one apartment. Create a document that details each member’s rights and responsibilities. Decide as a group whether the lease should be in one person’s name or in all your names. Explain the pros and cons of both approaches.
The Global View (AACSB)
You’re looking forward to taking a month-long vacation to Australia when you graduate from college in two years. Create a budget for this trip after researching likely costs. Determine how much you’ll need for the trip and calculate how much you’d have to save each month to afford the trip.
1. Financial planner Elissa Buie helped to develop USA TODAY’s Financial Diet. USA TODAY’s Financial Diet, which ran in USA Today in 2005 (accessed November 10, 2011). Go to http://www.usatoday.com/money/perfi/basics/2005-04-14-financial-diet-excercise1_x.htm and use the embedded links to follow the entire series.
2. Irby, L., “10 Key Changes of the New Credit Card Rules,” About.com, http://credit.about.com/od/consumercreditlaws/tp/new-credit-card-rules.htm (accessed November 10, 2011).
3. Gerson, E. S., and Jeremy M. Simon, “10 Ways Students Can Build Good Credit,” CreditCards.com, http://www.creditcards.com/credit-card-news/help/10-ways-students-get-good-credit-6000.php (accessed November 10, 2011).
4. Brackey, H. J., “Students Burdened by Overdraft Charges, Group Says,” Wisdom of the Rich Dad, http://www.richdadwisdom.com/2007/12/students-burdened-by-overdraft-charges/ (accessed November 11, 2001).
5. Chu, K., “Debit Card Overdraft Fees Hit Record Highs,” USA Today, January 24, 2007, http://www.usatoday.com/money/perfi/credit/2007-01-24-debit-card-fees_x.htm (accessed November 11, 2011).
6. Board of Governors of the Federal Reserve System, “What You Need to Know: Bank Account Overdraft Fees,” Board of Governors of the Federal Reserve System, http://www.federalreserve.gov/consumerinfo/wyntk_overdraft.htm (accessed November 10, 2011).
7. Prater, C., “Consumers to Fed: Stop Debit Card Overdraft Opt-In ‘Scare’ Tactics: New Debit Card Overdraft Rules Slated to Start July 1, 2010,” CreditCards.com, http://www.creditcards.com/credit-card-news/debit-card-overdraft-fee-opt-in-rules-1282.php (accessed November 10, 2011).
8. Frankieleon – won’t hurt you no more– CC BY 2.0
9. CreditCards.com, “Credit Card Statistics, Industry Facts, Debt Statistics,” CreditCards.com, http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php (accessed November 10, 2011).
10. Wyden, R., quoted in “Avoiding the Pitfalls of Credit Card Debt” (Center for American Progress Action Fund, 2008), http://www.americanprogressaction.org/issues/2008/avoiding_pitfalls.html (accessed September 13, 2008).
11. Lipton, J., “Choking On Credit Card Debt,” Forbes.com, September 12, 2008, http://www.forbes.com/finance/2008/09/12/credit-card-debt-pf-ii-in_jl_0911creditcards_inl.html (accessed November 11, 2011).
12. Lipton, J., “Choking On Credit Card Debt,” Forbes.com, September 12, 2008, http://www.forbes.com/finance/2008/09/12/credit-card-debt-pf-ii-in_jl_0911creditcards_inl.html (accessed November 11, 2011).
13. Financial planner Elissa Buie helped to develop USA TODAY’s Financial Diet.
14. Sun Trust Banks, “Money Management” (2008), http://www.suntrusteducation.com/toolbox/moneymgt_spendless.asp (accessed September 16, 2008)
15. SavingAdvice.com, “Reduce ATM Fees—Daily Financial Tip,” SavingAdvice.com, April 5, 2006, http://www.savingadvice.com/blog/2006/04/05/10533_reduce-atm-fees-daily-financial-tip.html
16. Loeb, M., “Four Ways to Keep ATM Fees from Draining Your Bank Account,” MarketWatch (June 14, 2007), http://www.marketwatch.com/news/story/four-ways-keep-atm-fees/story.aspx?guid=%7BEFB2C425-B7F8-40C4-8720-D684A838DBDA%7D (accessed November 11 2011)
17. Rosenberger, K., “How to Avoid ATM Fees,” Helium (2008), http://www.helium.com/items/1100945-how-to-avoid-atm-fees (accessed November 11, 2011).
18. Arrington, M., “eBay Survey Says Americans Buy Crap They Don’t Want,” TechCrunch, August 21, 2008, http://techcrunch.com/2008/08/21/ebay-survey-says-americans-buy-crap-they-dont-want/ (accessed November 11, 2011).
19. Keown, A. J., Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 8–11.
20. Keown, A. J., Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 8–11.
21. U.S. Census Bureau, “One-Third of Young Women Have Bachelor’s Degrees” (U.S. Department of Commerce, January 10, 2008), http://www.census.gov/Press-Release/www/releases/archives/education/011196.html (accessed September 18, 2008).
22. U.S. Census Bureau, “One-Third of Young Women Have Bachelor’s Degrees” (U.S. Department of Commerce, January 10, 2008), http://www.census.gov/Press-Release/www/releases/archives/education/011196.html (accessed September 18, 2008).
23. Hansen, K., “What Good Is a College Education Anyway?” Quintessential Careers (2008), http://www.quintcareers.com/college_education_value.html (accessed November 11, 2011).
24. Ramsay, J. G., Perlman Center for Learning and Teaching, quoted by Katharine Hansen, “What Good Is a College Education Anyway?” Quintessential Careers (2008), http://www.quintcareers.com/college_education_value.html (accessed November 11, 2011).
25. Roth, J. D., “The Value of a College Education,” Get Rich Slowly, January 10, 2008, http://www.getrichslowly.org/blog/2008/01/10/the-value-of-a-college-education/ (accessed November 11, 2011).
26. http://data.bls.gov/cgi-bin/print.pl/news.release/ecopro.t06.htm (November 11, 2011).
27. Penrice, D., “Major Moolah: Adding Up the Earnings Gaps in College Majors,” N.U. Magazine, January 1999, http://www.northeastern.edu/magazine/9901/labor.html (accessed November 11, 2011).
28. Harrington, P., and Andrew Sum, “The Post-College Earnings Experiences of Bachelor Degree Holders in the U.S.: Estimated Economic Returns to Major Fields of Study,” in Learning and Work on Campus and on the Job: The Evolving Relationship between Higher Education and Employment, ed. S. Reder, B. A. Holland, and M. P. Latiolais (in preparation).
29. Penrice, D., “Major Moolah: Adding Up the Earnings Gaps in College Majors,” N.U. Magazine, January 1999, http://www.northeastern.edu/magazine/9901/labor.html (accessed November 11, 2011).
30. Witmer, D., “The Basics of Financial Aid for College,” About.com, http://parentingteens.about.com/od/collegeinfo/a/financial_aid.htm (accessed November 11, 2011).
31. Federal Student Aid, “Federal Pell Grant,” http://studentaid.ed.gov/PORTALSWebApp/students/english/PellGrants.jsp?tab=funding (accessed November 11, 2011).
32. Snyder, S., “College lending tight but available,” The Philadelphia Inquirer, August 18, 2008, http://www.philly.com/inquirer/education/20080818_College_lending_tight_but_available.html (accessed November 11, 2011).
33. This section is based in part on sections 13 and 14 of the Playbook for Life by The Hartford. The Playbook can be found on line at http://www.playbook.thehartford.com (accessed November 11, 2011).
34. Isaacs, K., “Lying on Your Resume: What Are the Career Consequences?,” Monster.com, http://insidetech.monster.com/careers/articles/3574-lying-on-your-resume-what-are-the-career-consequences (accessed November 11, 2011).
35. Yaniv Yaakubovich – Trying my suite before the interview – CC BY-ND 2.0
36. Gallager, T. J., and Joseph D. Andrews Jr., Financial Management: Principles and Practice, 3rd ed. (Upper Saddle River, NJ: Prentice Hall, 2003), 34, 196.
37. Source: Data from Consumer Credit Counseling Service of Maryland and Delaware Inc., “Power of Saving Early” (2008), http://www.cccs-inc.org/tools/tools_saving_early.php (accessed November 15, 2008).
38. This 12 percent interest rate is not realistic for today’s economic environment. It’s used for illustrative purposes only.
39. Keown, A. J., Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 23.
40. Source: Arthur J. Keown, Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007), 23.
41. Clements, J., quoted in “An Interview with Jonathan Clements—Part 2,” All Financial Matters, February 10, 2006, http://allfinancialmatters.com/2006/02/10/an-interview-with-jonathan-clements-part-2/ (accessed November 11, 2011).
42. Kapoor, J. R., Les R. Dlabay, and Robert J. Hughes, Personal Finance, 8th ed. (New York: McGraw-Hill, 2007), 81.
43. Winger, B. J., and Ralph R. Frasca, Personal Finance: An Integrated Planning Approach, 6th ed. (Upper Saddle River, NJ: Prentice Hall, 2003), 57–58.
44. Keown, A. J., Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007, 22 et passim.
45. Frank, R. H., “Americans Save So Little, but What Can Be Done to Change That?” New York Times, March 17, 2005, http://www.robert-h-frank.com/PDFs/ES.3.17.05.pdf (accessed November 11, 2011).
46. Taylor, D., “Two-Thirds of Americans Don’t Save Enough,” Bankrate.com, October 2007, http://www.bankrate.com/brm/news/retirement/Oct_07_retirement_poll_results_a1.asp (accessed November 11, 2011).
47. Frank, R. H., “Americans Save So Little, but What Can Be Done to Change That?” New York Times, March 17, 2005, http://www.robert-h-frank.com/PDFs/ES.3.17.05.pdf (accessed November 11, 2011).
48. Gardner, M., “Why Can’t Americans Save a Dime?” Christian Science Monitor (2008), http://www.mrshultz.com/webpages/whycantamericanssave.htm (accessed November 11, 2011).
49. Rubin, R. M., Shelley I. White-Means, and Luojia Mao Daniel, “Income Distribution of Older Americans,” Monthly Labor Review, November 2000, http://www.bls.gov/opub/mlr/2000/11/art2full.pdf (accessed November 11, 2011).
50. Economic Research, “Personal Savings Rate (PSAVERT),” Economic Research, Federal Reserve Bank of St. Louis, August 28, 2008, http://research.stlouisfed.org/fred2/series/PSAVERT (accessed November 10, 2011).
51. Dickson, A., “U.S. Personal Savings Rate Close to Depression-Era Rates,” Wisebread, February 2, 2007, http://www.wisebread.com/u-s-personal-savings-rate-close-to-depression-era-rates (accessed November 11, 2011).
52. Federal Reserve Bank of San Francisco, “Spendthrift Nation,” Economic Research and Data, November 10, 2005, http://www.frbsf.org/publications/economics/letter/2005/el2005-30.html (accessed November 11, 2011).
53. Associated Press, “How Severe Is Subprime Mess?” MSNBC.com, March 13, 2007, http://www.msnbc.msn.com/id/17584725/ns/business-real_estate/t/will-subprime-mess-ripple-through-economy/#.Tr2hFvKul2I (accessed November 11, 2011).
54. consumeraffairs.com, “Subprime Mortgage Pricing Varies Greatly among U.S. Cities, consumeraffairs.com, September 13, 2005, http://www.consumeraffairs.com/news04/2005/subprime_study.html (accessed November 11, 2011).
55. Lahart, J., “Egg Cracks Differ in Housing, Finance Shells,” Wall Street Journal, July 13, 2008.
56. RealtyTrac Inc., “Foreclosure Activity Increases 4 Percent in April According to RealtyTrac(R) U.S. Foreclosure Market Report,” PR Newswire, May 14, 2008, http://www.prnewswire.com/news-releases/foreclosure-activity-increases-4-percent-in-april-according-to-realtytracr-us-foreclosure -market-report-57244677.html (accessed November 11, 2011).
57. Mortgage Bankers Association, “Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey,” Press Release, September 5, 2008, http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm (accessed November 11, 2011).
58. Duhigg, C., “Loan-Agency Woes Swell from a Trickle to a Torrent,” nytimes.com, July 11, 2008, http://www.nytimes.com/2008/07/11/business/11ripple.html?ex=1373515200&en=8ad220403fcfdf6e&ei=5124&partner=permalink &exprod=permalink.
59. Taber Andrew Bain – Foreclosure – CC BY 2.0.
60. Federal Deposit Insurance Corporation, Quarterly Banking Profile (Fourth Quarter 2007), http://www.2.fdic.gov/qbp/2007dec/qbp.pdf (accessed September 25, 2008).
61. FDIC, Quarterly Banking Profile (First Quarter 2008), http://www.2.fdic.gov/qbp/2008mar/qbp.pdf (accessed September 25, 2008).
62. Tully, S., “Wall Street’s Money Machine Breaks Down,” Fortune, CNNMoney.com, November 12, 2007, http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm (accessed November 11, 2011).
63. Robb, G., et al., “AIG Gets Fed Rescue in Form of \$85 Billion Loan,” MarketWatch, September 16, 2008, http://www.marketwatch.com/News/Story/aig-gets-fed-rescue-form/story.aspx?guid=%7BE84A4797%2D3EA6%2D40B1%2D9DB5%2DF07B5A7F5BC2%7D (accessed November 11, 2011).
64. Mortgage Bankers Association, “Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey,” Press Release, September 5, 2008, http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm (accessed November 11, 2011).
65. Financial Crimes Enforcement Network, Mortgage Loan Fraud: An Industry Assessment Based upon Suspicious Activity Report Analysis, November 2006, http://www.fincen.gov/news_room/rp/reports/pdf/MortgageLoanFraud.pdf (accessed November 11, 2011).
66. Keown, A. J., Personal Finance: Turning Money into Wealth, 4th ed. (Upper Saddle River, NJ: Pearson Education, 2007, 253–54.
67. Keown, A. J., et al., Foundations of Finance: The Logic and Practice of Financial Management, 6th ed. (Upper Saddle River, NJ: Pearson Education, 2008), 174.
68. Winger, B. J., and Ralph R. Frasca, Personal Finance: An Integrated Planning Approach, 6th ed. (Upper Saddle River, NJ: Prentice Hall, 2003), 250–51.
69. Economist.com, “Getting Worried Downtown,” Economist.com, November 15, 2007, http://www.economist.com/world/unitedstates/displaystory.cfm?story_id=10134077 (accessed November 11, 2011).
70. Streitfeld, D., “Bottom May Be Near for Slide in Housing,” The New York Times, May 31, 2011, http://www.nytimes.com/2011/06/01/business/01housing.html (accessed November 10, 2011).
71. Walayat, N., “U.S. House Prices Forecast 2008-2010,” Market Oracle, June 29, 2008, http://www.marketoracle.co.uk/Article5257.html (accessed November 11, 2011).
72. Doll, S. L., of Capital Performance Advisors, quoted by Amy Hoak, “Why a House Is Not a Piggy Bank to Tap Into for Your Retirement,” Wall Street Journal, July 19, 2006, http://homes.wsj.com/buysell/markettrends/20060719-hoak.html (accessed September 27, 2008).
73. Hoak, A., “Why a House Is Not a Piggy Bank to Tap Into for Your Retirement,” Wall Street Journal, July 19, 2006, http://homes.wsj.com/buysell/markettrends/20060719-hoak.html (accessed September 27, 2008). | textbooks/biz/Management/Maritime_Management%3A_Micro_and_Small_Businesses_(Pauley)/03%3A_Accounting_and_Finances/3.03%3A_Chapter_12-_Personal_Finances.txt |
Subsets and Splits
No community queries yet
The top public SQL queries from the community will appear here once available.