Organisations

1 Introduction to organisations

An organisation can be defined as:

This is a deceptively simple definition, and each of its four parts is doing work.

Social. Organisations consist of people, and people are social animals. We have to get on with our colleagues; ideally we would like our boss, or at least respect our boss. We have to get on with customers. We have our own ambitions and our own motivations, and they are not the organisation’s. Early management theory tended to neglect the social side of organisations and took a rather cold, militaristic approach — issue an order and expect it to be obeyed without question. Modern theories have changed that considerably.

Collective goals. There has to be an assumption that the people inside an organisation are ultimately aiming at the same result. If they are not, chaos is likely to rule. A profit-seeking organisation has profit as its goal; a state hospital has a goal of curing patients. One of the functions of management is to arrange the business and the people in it so that everyone is pulling in the same direction.

Controls its own performance. An organisation measures what it is doing against what it intended to do, and acts on the difference. That is why management information exists, and it is why every measure in section 4 of this chapter exists.

A boundary separating it from its environment. Inputs cross the boundary in and outputs cross it out. In a manufacturing company the inputs might be steel, timber and power, and the output a finished product. In a firm of accountants the inputs are information taken from clients — records, financial statements, explanations — and the output is a completed audit. The boundary is the same idea in both cases even though nothing physical crosses it in the second.

Through sharing skills and pooling resources, an organisation can accomplish tasks that single individuals could not. That is the reason organisations exist at all, and section 5 returns to it: it is also the reason they grow.

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2 Types of organisations

You need to be aware of the characteristics of several types of organisation, and of what each of them is FOR — the syllabus asks you to distinguish between the goals of profit-seeking, not-for-profit and governmental organisations.

2.1 Profit-seeking organisations

Commercial organisations are profit-seeking. They can be sole traders, partnerships, limited liability partnerships or limited companies. The main advantage of the limited liability partnership and the limited company is that if the organisation hits hard times and has to be liquidated, the owners are protected: creditors and banks can pursue only the assets that are in the entity. Sole traders and ordinary partners have unlimited liability for all the business’s debts, which means their private assets are at risk.

2.2 Not-for-profit organisations

Not-for-profit organisations do not seek to make profits. A charitable hospital whose objective is curing patients is a good example. Instead of a statement of profit or loss they tend to produce an income and expenditure account. That does not mean the money does not matter: ultimately their income has to exceed their expenditure or they will run out of money and stop. What changes is the objective the money is in service of.

2.3 Public sector organisations

Public sector organisations are owned by the state, either nationally or locally — a defence department, many health services, most educational systems. In some economies other industries are state-owned too; several national airlines are.

2.4 Non-governmental organisations

Non-governmental organisations tend to be not-for-profit but with an international brief. They are not part of any government, though they can receive government funding. Many United Nations bodies fall into this category, as do organisations such as Oxfam and Greenpeace. There is a considerable overlap between the terms NGO and charity: in the UK, ‘charity’ is reserved for organisations that have registered as charities and which then enjoy substantial tax advantages.

2.5 Co-operatives and other mutually owned organisations

A co-operative is owned by the people who work in it or who supply it. Coffee farmers are the classic case. Individually, each farm is small, sells a small lot and takes whatever price the buyer offers. Pooled through a co-operative, the crop is combined and sold as one large lot, and the negotiation goes rather better. The members usually seek some sort of profit, but the ownership — and therefore the surplus — is shared widely among the people doing the work. Building societies and mutual insurers are the same idea in financial services.

3 Shareholders and companies

Limited liability companies are the predominant type of profit-seeking organisation, and everything from here to the end of section 4 is about them.

Companies are owned by their shareholders, who contribute capital and receive a share of the company’s profits in the form of dividends. ‘Limited liability’ means that if the company becomes insolvent, a shareholder’s liability is limited to losing what they paid for their shares; their private wealth is protected.

Once a company grows, the day-to-day management is normally carried on by directors and managers who can be quite separate from the shareholders. A large company has thousands of shareholders and there is no way a group that size could run it. That separation is convenient, and it is also the source of the problem section 7 deals with.

Directors should run the company for the benefit of the shareholders, who are, after all, the owners. That means running it with the objective of maximising shareholder wealth.

3.1 Shareholder wealth and the cost of capital

Shareholder wealth has two sources:

• dividends paid to them out of profits; and

• the value of the shares they own.

Most companies also obtain capital by borrowing from banks and other investors. Interest has to be paid to the suppliers of loan capital, and loans are usually secured: the lender has an agreement that if the interest or the principal is not paid, it can take a specified asset — the company’s premises, say — sell it and reimburse itself. Because the lender’s risk is lower than the shareholder’s, and because interest is deductible for tax where dividends are not, loan capital is normally cheaper than equity.

Cash earned by a company is therefore used for three purposes:

• the payment of dividends to shareholders. As a company’s activities become riskier, shareholders want higher dividends to compensate for the risk;

• loan interest; and

• the residual, which can be invested in company assets. Those assets should produce more profits, which in turn should lead to higher share prices.

This is the SHORT-RUN and LONG-RUN distinction the syllabus asks for, in its simplest form: the dividend is a return this year, the share price is the market’s view of every return after that, and the cost of capital is the hurdle both have to clear. Section 4.4 returns to it once the measures are in place.

4 Measurement of company performance

Three important measures of company performance are used by shareholders:

• return on capital employed;

• return on equity; and

• earnings per share.

All three are worked below on the same company, so that you can see what each of them is measuring and where the three differ.

4.1 Return on capital employed

Return on capital employed = operating profit before tax and interest ÷ capital employed × 100%.

Interest is excluded from the top line because it is a reward to one of the suppliers of the capital that forms the bottom line; including it would net a return against part of the base that produced it. Tax is excluded because it is largely outside the directors’ control.

Capital employed = share capital + retained profits (reserves) + long-term loans. Usually the closing figure is used; if the average of opening and closing capital employed is used instead, the ratio is called the return on AVERAGE capital employed.

On the figures in Example 1, capital employed = 17,000 + 4,500 = 21,500 and

ROCE = 4,000 ÷ 21,500 × 100 = 18.6%.

The higher the ROCE, the better the company is at turning the capital it has been given into profit. Compare it with the cost of capital in section 3.1: a company earning 18.6% on capital that costs it 10% is creating value; one earning 6% on the same capital is destroying it.

4.2 Return on equity

Return on equity = operating profit after interest and before tax ÷ shareholders’ equity × 100%.

Usually the closing equity figure is used. Shareholders’ equity = share capital + retained profits, and does NOT include long-term loans — that is the whole difference between this measure and ROCE. Interest is deducted from the top line for the same reason: the equity holders are paid after the lenders, so what is left after interest is what the equity is earning.

On the figures in Example 1,

ROE = 3,000 ÷ 17,000 × 100 = 17.6%.

4.3 Earnings per share

Earnings per share = profits after interest, tax and preference dividends ÷ number of equity shares.

Preference shares are a relatively uncommon type of share that pays a fixed dividend, expressed as a percentage of the share’s par value. An 8% preference share with a par value of 50 cents pays 4 cents a year, because 8% × 50c = 4c — and it pays that whether the company has a good year or a bad one. Equity shareholders are regarded as the true owners of a company, and it is they who benefit most from better earnings, which is why the preference dividend comes off the top line here.

On the figures in Example 1 the company has 5,000,000 $1 shares and profit after tax of $2,100,000, so EPS = 2,100 ÷ 5,000 = 42 cents.

If a company manages to earn more without having to issue more shares, that is good for the equity shareholders. If it issues shares and the money raised does not go on to make decent profits, EPS falls even though total profit has risen. That is why EPS, and not profit, is the number the market watches.

4.4 Short-run and long-run performance

Directors of companies, particularly those listed on a stock exchange, are under immense scrutiny and under pressure to improve results continually. Disappointing results often lead to a fall in the share price.

To avoid a fall in current profits, directors could cut back on expenditure such as research and development, training and maintenance. That would raise this year’s profit. It would also cause difficulties and profit falls in later years, when no new products have been developed, good staff have left because they were not getting the training they wanted, and the premises look shabby to customers. It is the same as skipping the routine maintenance on a car: this month is cheaper and the expensive breakdown arrives later.

This is the SHORT-TERM/LONG-TERM CONFLICT: short-term results improved at the expense of long-term results. It is a particular problem for listed companies, where a director may be in office temporarily and wants a good current record — which can be used to get a better job elsewhere, leaving the consequences behind. It is less of a problem in private and family companies, where the emphasis is more likely to be on the long-term benefit of the business and on future generations.

To reduce the pull of short-term influences, longer-term measures of performance are needed. The most commonly used approach is to estimate all the future cash inflows the company will receive and to base its value on them. Research and development may hurt this year’s reported result, but the promise of a successful new product and the cash flows that will come from it increases the value of the company, its shares, and its shareholders’ wealth.

Cash to be received in ten years’ time is not worth as much as cash received now, so the technique of DISCOUNTING is used to reduce those future inflows to their present-value equivalents. The share price is supported by the present value of the company’s future inflows. Discounting itself is taught in chapter 10.

5 Costs, economies of scale and the size of the organisation

Everything so far has treated the organisation’s size as given. It is not. The syllabus asks you to identify the influence of costs on the size and structure of the organisation, and the mechanism it names is economies of scale.

5.1 Internal economies of scale

There are six standard sources, and each of them is a different reason why a bigger firm can produce a unit more cheaply than a smaller one.

5.2 External economies of scale

External economies of scale come from the growth of the INDUSTRY rather than of the firm, and every firm in the industry gets them whether it grew or not.

• A pool of skilled labour builds up in the area, so recruitment and training are cheaper for everybody in it.

• Specialist suppliers and subcontractors set up nearby because there is now enough demand to support them, so components and services are cheaper and quicker to get.

• Infrastructure follows the industry — transport links, power supply, broadband — usually paid for by somebody else.

• Knowledge spreads. Research institutes and universities begin to teach and publish in the field, and staff move between firms carrying what they know.

This is why industries cluster: software in a handful of cities, financial services in a handful of others, film production in a very few. A firm that moves into the cluster gets the external economies on its first day.

5.3 Economies of scale and market concentration

Now put the two together. If economies of scale are LARGE relative to the size of the market, then a firm that grows gets cheaper as it grows, and a firm that is already large can undercut a smaller rival while still making a profit. The small rival either grows, is bought, or leaves. The market ends up served by a few large firms rather than by many small ones: it becomes CONCENTRATED.

If economies of scale are SMALL relative to the market — as they are in hairdressing, plumbing or restaurants — a big firm has no cost advantage worth having, and the market stays fragmented among many small firms.

The extreme case is where the economies of scale are so large that a single firm supplying the whole market is cheaper than any two firms supplying half each. That is a NATURAL MONOPOLY, and it is why electricity distribution, water and rail track are supplied by one network rather than by competing ones. Chapter 6 section 2 takes that case up as a source of market failure.

Growth does not go on being cheaper for ever. Beyond some size, an organisation begins to suffer DISECONOMIES of scale — communication becomes slower and less accurate, coordination absorbs more management time, and individual staff feel less connected to the result, so motivation falls. The average cost per unit starts to rise again. In practice this is what limits the size of the firm, and it is why the largest organisations tend to be run as groups of smaller units rather than as one block.

6 Stakeholders

The term STAKEHOLDER refers to any person or institution affected in any way by an organisation. Stakeholders are conventionally broken into three groups.

Why does the study of stakeholders matter? Because what stakeholders want is usually in conflict. Shareholders want higher profits and employees want higher wages. Customers want better quality at lower prices; shareholders want better margins. Customers may want the operation to run 24 hours a day, seven days a week, while employees want to work five days and eight hours. If the organisation is an airport, the local population wants fewer flights and certainly none after eleven at night, while customers and shareholders want more of them.

There is no neat way of resolving these conflicts. It comes down to management getting stakeholders to compromise — keeping most people happy most of the time — bearing in mind that some stakeholders can stop co-operating altogether. Employees who want better wages can strike, and that ultimately hits the profits the shareholders were protecting.

6.1 Mendelow’s matrix

About the only model available for analysing stakeholders is Mendelow’s matrix. One axis is the POWER a stakeholder can bring to bear; the other is their INTEREST, by which we mean how likely they are actually to use it.

KEY PLAYERS have both the power and the willingness to use it, and management really has to keep them happy. Flight attendants at an airline are a good example: they are usually well organised, and without them the aircraft does not fly.

KEEP SATISFIED covers stakeholders with high power who are unlikely to act even when they dislike what management is doing, often for professional or ethical reasons. Nurses are the standard case: a hospital cannot function without them, and it is very unusual for them to strike. Management can be less careful here — but only up to a point, because a stakeholder in this box who is pushed far enough turns into a key player.

KEEP INFORMED covers people with low power but high interest. They cannot do much themselves, but they can influence key players to act on their behalf, which is exactly what a well-run local campaign does.

MINIMAL EFFORT covers low power and low interest. Management can largely leave these stakeholders alone — with the same caveat as above, that the boxes are not permanent.

7 The principal-agent problem and corporate governance

Section 3 described how shareholders own companies while directors run them from day to day on the shareholders’ behalf.

• Shareholders are the PRINCIPALS.

• Directors are the AGENTS.

It is the duty of agents to act in the best interests of their principals. Shareholders and directors are two kinds of stakeholder, and what they want can conflict. For example:

• shareholders want larger profits; directors may want larger fees, better cars and first-class travel;

• shareholders want a particular level of risk; a director may want to take an unjustifiable gamble on the company’s future, because if it comes off their reputation is made and if it does not, they move on.

That conflict is the PRINCIPAL-AGENT PROBLEM, and it has been very serious in some companies.

7.1 Corporate governance

Corporate governance can be defined as “the way in which companies are directed and controlled”, and it should be directed and controlled in ways that keep shareholders’ requirements paramount. After a series of high-profile financial scandals, many countries introduced corporate governance rules. In the UK these are the UK Corporate Governance Code, and listed companies are expected to COMPLY OR EXPLAIN: a company that departs from the code must say so and justify it, and its listing is jeopardised if it cannot.

The main provisions are as follows.

1. The chief executive officer and the chairman have to be separate people. This splits power at the top. The scandals it is aimed at typically featured one very powerful, charismatic and frequently bullying figure at the top whom none of the other directors would contradict.

2. There should be a balance of executive and non-executive directors — roughly 50/50. Non-executive directors play no part in day-to-day management but attend board meetings and vote. Their purpose is to warn and to advise the executive directors.

3. A remuneration committee, composed of non-executive directors, decides on the executive directors’ remuneration. Non-executive directors are themselves paid a fixed fee rather than a profit-related one, so that they have no incentive to wave through a risky strategy.

4. A nomination committee, principally of non-executive directors, recommends new and replacement directors.

5. An audit committee, of non-executive directors, liaises with both the internal and the external AUDITORS.

6. Directors are responsible for the long-term strategy of the company.

7. Directors are responsible for designing and implementing a good system of internal control.

Each of these is a direct answer to a principal-agent problem: the agent has an incentive the principal does not share, and the provision either removes the incentive or puts somebody independent in the room.

8 Tests

The chapter’s own eight questions follow. Work each one before you open the answer.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.