Professional Documents
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Introduction to business
Contents
Introduction
Examination context
Topic list
1
What is an organisation?
What is a business?
Introduction
Learning objectives
Identify the key features of businesses as distinct from other forms of organisation
Identify how a business measures whether its objectives have been met
Tick off
Practical significance
Appreciating what is meant by the term 'business' underlies everything that we study in this paper and
others at Professional level.
Working context
As you build up your exposure to different organisations in audit or other professional engagements, you
will begin to see that while they vary tremendously in their operations and environment, the fundamental
features of business organisations remain the same.
Syllabus links
The material in this chapter will be developed further in this paper, and then in the Business Strategy paper
at the next level in the Professional stage.
INTRODUCTION TO BUSINESS
Examination context
Examination commentary
While the material in this chapter is essentially introductory, questions on business objectives will be
directly examined.
Exam requirements
Questions are likely to be set either as a straight test of knowledge or in a scenario.
1 What is an organisation?
Section overview
1.1
There are many different types of organisation in both the not-for-profit and business sectors.
Organisations exist because the collective efforts of people are more productive as a result of them.
All organisations share the feature that they are designed to get things done.
Organisations differ in terms of ownership, control, activity, profit orientation, size, legal status and
technology.
Introduction to organisations
Here are some examples of organisations, categorised as to whether they are profit-oriented or not-forprofit.
1.2
Save time, because people can work together or do two aspects of a different task at the same time
Accumulate and share knowledge (e.g. about how best to build cars)
Enable synergy: the combined output of two or more individuals working together exceeds their
individual output ('None of us is as smart as all of us').
1.3
Definition
Organisation: A social arrangement for the controlled performance of collective goals, which has a
boundary separating it from its environment.
INTRODUCTION TO BUSINESS
The following table shows how this definition applies to two organisational examples: a car manufacturer
and an army.
1.4
Characteristic
Car manufacturer
(e.g. Ford)
Army
Controlled performance:
performance is monitored against
the goals and adjusted if
necessary to ensure the goals are
accomplished
Physical: barracks
Example
Control
Size
Legal status
Sources of finance
Technology
High use of technology (e.g. computer firms) v low use (e.g. corner
shop)
1.4.1
Activity
Agriculture
Manufacturing
Extractive/raw materials
Energy
Retailing/distribution
Intellectual production
Service industries
2 What is a business?
Section overview
2.1
For a profit-making organisation, the primary objective is to maximise the wealth of its owners; for
a non-profit organisation it is to provide goods and services for its beneficiaries.
A business is an organisation which aims to maximise its owners' wealth but which can be regarded
as an entity separate from its owners.
Not-for-profit
organisation
Profit-oriented
organisation
PRIMARY
OBJECTIVE
SECONDARY
OBJECTIVE
OWNERS
PUBLIC BENEFICIARIES
MAXIMISE PROFIT/
DIVIDEND/WEALTH
PROVISION OF
GOODS/SERVICES
PROFIT
OUTPUT
(GOODS/SERVICES)
OUTPUT OF
GOODS/SERVICES
INPUTS (MATERIALS,
LABOUR, FINANCE)
REVENUE FROM
GOODS/SERVICES
COSTS
MINIMISE COST OF
PRIMARY GOAL
INPUTS (MATERIALS,
LABOUR, FINANCE)
REVENUE (TAXATION)
INTRODUCTION TO BUSINESS
Profit-oriented organisations are generally referred to as 'businesses', though this is in fact a rather
loose term.
Businesses are profit-oriented but they encompass a variety of legal structures (as we shall see in
Chapter 3):
Not-for-profit organisations are frequently structured and run on the lines of a business, so that they
benefit from the economy, efficiency and effectiveness in using resources that profit orientation brings,
but they are not generally owned by shareholders, proprietors or partners. They do not primarily aim
to maximise profit or the wealth of their owners, but rather are focused on providing goods and
services to their beneficiaries at minimised cost.
The type of work engaged in by the organisation does not of itself determine whether it is a profitorientated or not-for-profit organisation; a business can be involved in providing medical or education
services just as much as can a charitable or government organisation.
2.2
Charities
Clubs and associations
Trade unions
Professional institutes such as the ICAB
Government
Governmental agencies
Local authorities
Hospitals
Schools
Definition of a business
It is the primary objective of the organisation that determines whether or not it is a business. Although
as we have seen 'business' is a loose term which has no legal definition as such, it is useful to have a working
definition at this point.
Definition
Business: An organisation (however small) that is oriented towards making a profit for its owners so as to
maximise their wealth and that can be regarded as an entity separate from its owners.
A company's primary stakeholders are its shareholders. The primary stakeholders in a sole
tradership or partnership also comprise the business's owners. Secondary stakeholders are
directors/managers, employees, customers, suppliers and partners, lenders, government and its
agencies, the local community, the public at large and the natural environment.
The social responsibility of a business can encompass the natural environment, human resource
policies, sustainable business practices, charitable support and high standards of workplace health
and safety.
Definition
Stakeholder: Literally a person or group of persons who has a stake in the organisation. This means that
they have an interest to protect in respect of what the organisation does and how it performs.
For a business formed as a company the primary stakeholders are its shareholders. It is their money,
invested in the business, which is literally 'at stake'; it can be lost if the business performs badly, and it can
earn a decent return if the business does well. The business owes it to the shareholders to look after their
interests, but it has secondary stakeholders as well, to whom it also has responsibilities, and from whom it
may receive pressure.
P
R
I
M
A
R
Y
Stakeholders in a
business
What is at stake?
Shareholders (or
partners or proprietor)
Money invested
Directors/managers
Employees and trade
unions
Customers
Their custom
S
E
C
O
N
D
A
R
Y
Continuity of supply
Suppliers and other
business partners
Lenders
Money lent
Tax revenue
The local community and
the public at large
INTRODUCTION TO BUSINESS
What expectations would the local community have of a company operating a coal-fired power station
within two miles of a medium-sized town?
See Answer at the end of this chapter.
Therefore, there are wider areas of social responsibility of which the business must take account:
Its human resource management policies: for example, the hiring and promotion of people from
minority groups, policies on sexual harassment, refusal to exploit cheap labour in developing countries
Charitable support and activity in the local community or in areas related to the organisation's field
of activity
Above-minimum (legal) standards of workplace health and safety, product safety and labelling,
and so on.
4.1
Every business has a hierarchy of objectives, from its primary objective down to its supporting
secondary objectives. Together these form multiple objectives.
Profit and wealth maximisation is usually the primary objective, though sometimes managers pursue
a policy of profit satisficing only.
4.1.1
Primary objective
For a business the primary objective is the financial objective of profit maximisation so as to
increase shareholder wealth.
Profit is revenue less costs. It measures the creation of value, in terms of the relationship of inputs
to outputs, with the cost of inputs (labour, materials and finance) being less than the ultimate output,
which is the revenue generated. Profit thus integrates cost behaviour and revenue performance for the
whole organisation.
The link between profit and shareholder wealth is that the latter can only be maximised if profit is
earned at an acceptable level of risk: focussing solely on maximising profit and ignoring risk can lead to
decreased shareholder wealth (and financial collapse). Thus avoiding high risk should go hand in hand
with making profits so as to maximise shareholder wealth.
Profit cannot be pursued at any cost. Any business is subject to the law of the country in which it
operates, and it will also have social responsibilities, as we saw above.
4.1.2
Secondary objectives
Secondary objectives support the primary objective.
Market position
Total market share of each market; growth of sales, customers or potential customers; the need to
avoid relying on a single customer for a large proportion of total sales; what markets should the
business be in?
Product development
Bring in new products; develop a product range; invest in research and development; provide products
of a certain quality at a certain price level
Technology
Improve productivity; reduce the cost per unit of output; exploit appropriate technology
4.2
4.2.1
They may have no personal interest in the creation of wealth, except insofar as they are
accountable to shareholders
There may be a lack of competitive pressure in the market to be efficient by minimising costs and
maximising revenue, for example where there are few businesses in the market
Profit satisficing
Decisions might be taken by managers with managerial objectives in mind rather than the aim of wealth
maximisation. The profit and risk levels must be satisfactory and so acceptable to shareholders, and they
must provide enough profits retained in the business for future investment in growth, but rather than
seeking to maximise profit and wealth, managers may choose to achieve simply a satisfactory profit for a
business. This is called 'satisficing', and is linked to a view of the strategy process called 'bounded
rationality' by Herbert Simon an issue we shall return to in Chapter 4.
4.2.2
Revenue maximisation
Baumol argued that the business acts to maximise revenue (not necessarily profit or wealth) in order to
maintain or increase its market share, ensure survival, and discourage competition. Managers benefit
personally because of the prestige of running a large and successful company, and also because salaries and
other benefits are likely to be higher in bigger companies than in smaller ones.
4.2.3
Multiple objectives
Management writer Peter Drucker points out that:
'To manage a business is to balance a variety of needs and goals. The very nature of business enterprise
requires multiple objectives'. He suggests that objectives are needed in eight key areas.
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INTRODUCTION TO BUSINESS
4.2.4
Market standing: this includes market share, customer satisfaction, size of product range and
distribution resources
Productivity: meeting targets for the number of outputs (items produced or tasks completed) within
set timescales
Physical and financial resources: efficient use (minimising waste) of limited resources (including
people, space, materials, plant and equipment, finance and so on)
Worker performance and attitude: labour productivity, stability (controlled labour turnover),
motivation and morale, development of skills and so on
Social responsibility: in areas such as community and environmental impacts, labour standards and
employment protection, business ethics and so on (as discussed earlier).
Constraints theory
Simon has pointed out that for some business areas decisions are taken without reference to the wealth
objective at all. This is not because they are ignoring profit, but because profit is not the most important
constraint in their business. This is perhaps seen most clearly in areas where ethical constraints apply,
such as staff relations or environmental protection. It may also be seen in the need to satisfy customers
with quality products and service which may lower profitability.
5.1
A business's planning and control cycle is designed to ensure that its objectives, mission and goals
are met by setting plans, measuring actual performance against plans, and taking control action.
The direction of the business is set by its mission, which sets out its basic function in society in
terms of how it satisfies its stakeholders.
The mission encompasses the business's purpose, strategy, policies, standards of behaviour and
values.
The business's goals can be classified as its aims (which are non-operational and qualitative) and its
operational, quantitative objectives.
Operational objectives should be SMART: specific, measurable, achievable, relevant and time-bound.
Plans and standards set out what should be done to achieve the operational objectives.
Deciding what they want to do to achieve the overall objective these become detailed objectives
that the business sets out to achieve, such as 'grow revenue by 20%' or 'reduce costs by 10%'
Deciding how and when to do it and who is to do it (setting plans and standards)
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Checking that they achieve what they want, by monitoring what has been done and comparing it
with the plan
The overall framework for this is the system of planning and control in Figure 1.2.
5.2
Mission
Overall, the main direction of a business is set by its mission.
Definition
Mission: 'The business's basic function in society', is expressed in terms of how it satisfies its stakeholders.
Elements of mission
Comments
Purpose
Why does the organisation exist and for whom (e.g. shareholders)?
Strategy
Mission should influence what people actually do and how they behave:
the mission of a hospital is to save lives, and this affects how doctors
and nurses interact with patients.
Values
Even though the mission can be very general, you can see it should have real implications for the policies
and activities of the organisation, and how individuals go about what they do.
5.2.1
Vision
Some businesses also set out their vision of the future state of the industry or business when determining
what its mission should be. For instance, 'being the leading provider of X by 2010' is a vision of the future,
which ties it in with a mission of 'providing high-quality environmentally-friendly X to all our customers'.
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INTRODUCTION TO BUSINESS
5.3
Goals give flesh to the mission. There are two types of goal:
Non-operational, qualitative goals (aims), for example, a university's aim may be: 'to seek truth'.
(You would not see: 'increase truth by 5%')
Operational, quantitative goals (objectives), for example, 'to increase sales volume by 10%'.
Characteristics of operational goals
(objectives)
Example
Specific
Measurable
Achievable
Relevant
Time-bound
Most organisations establish quantifiable operational goals (objectives). Give reasons why non-operational
goals (aims) might still be important.
See Answer at the end of this chapter.
5.3.1
5.4
Publicise the direction of the organisation to managers and staff, so that they know where their
efforts should be directed.
Appraise the validity of decisions (by assessing whether these are sufficient to achieve the stated
objectives).
Assess and control actual performance, as objectives can be used as targets for achievement.
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5.5
Cost standards. These convert physical standards into money measurement by the application of
standard prices. For example, the standard labour cost of making product X might be 4 hours at CU6
per hour = CU24.
Quality standards. These can take a variety of forms, such as percentage of phone calls answered
within three rings (customer service quality standard).
6.1
The business will know whether it has achieved its operational and strategic objectives only if it
measures its performance effectively.
Many businesses identify critical success factors (CSFs) to use as yardsticks against which
performance, and key performance indicators (KPIs), can be measured and compared.
Measuring performance
The planning and control system model in Figure 1.2 shows us that actual performance follows on from
setting operational objectives and developing plans and standards; what is achieved is then compared with
the plan so that control action may be taken to deal with any deviations. Provided this planning and control
model is followed effectively the organisation's objective should be achieved.
It is on measuring performance and making the comparison that a great deal of the work of the accountant
is focused. Each business will have different ways of measuring its performance and will place greater
emphasis on certain factors over others.
6.2
Profitability
Profit has two components: cost and revenue. All parts of a business and all activities within it incur
costs, and so their success needs to be judged in relation to cost (these will be called cost centres).
Only some parts of a business receive revenue, and their success should be judged in terms of both
cost and revenue (as profit centres).
Activity
All parts of a business are also engaged in activities (activities cause costs). Activity measures could
include the following.
Each of these items could be measured in terms of physical numbers, monetary value, or time
spent.
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INTRODUCTION TO BUSINESS
Productivity
This is the quantity of the service or product produced in relation to the resources put in, for example
so many items processed per hour or per employee. It defines how efficiently resources are being
used.
The dividing line between productivity and activity is thin, because every activity could be said to
have some 'product' (if not it can be measured in terms of lost units of product or service).
6.3
Measuring profitability
Profits consist of sales revenue less the costs of the business. Examples:
CU
100,000
(58,000)
42,000
(24,000)
18,000
It is then measured relatively, to build up a picture of the business's profitability. Three common measures
are gross and net margin (measured in relation to revenue) and (gross) markup (measured in relation to
cost of sales).
Gross margin: Gross profit/Revenue = CU42,000 % = 42%
CU100,000
Net margin: Net profit/Revenue = CU18,000 % = 18%
CU100,000
Markup: gross profit/cost of sales = CU42,000 % 72%
CU58,000
Alone these figures convey little meaningful information. What is needed is a comparison with what was
expected or what was wanted, or what similar businesses have achieved. A net margin of 18% is
extraordinarily high for some industries, but quite ordinary for others. Markups tend to be similar across
businesses in the same industry, but net margins can vary tremendously depending on overheads.
Profitability is also often measured in terms of return. For instance, suppose the profit of CU18,000 was
generated using assets that cost the business CU1,000,000. The return on capital employed (ROCE) is
CU18,000/CU1,000,000 = just 1.8%. If the business could get a rate of 4.5% on its capital elsewhere, this
return does not look so great.
If the desired level of profit is not achieved, the owner will close the business and try something else.
Exactly the same idea applies to large companies financed by shares: if shareholders do not receive what
they perceive to be an adequate return on their investment they will take their money elsewhere.
This concept of profit is important to the business's managers. If profit is to be a business's primary
objective, it must be specified in quantified terms, that is a specific target rate of profit must be set.
Effectively, this rate can only be determined by examining the opportunity cost of investing in the
business: this is given by the rate of profit available on alternative investments with similar
characteristics, particularly risk. This is then the minimum rate of return acceptable to the shareholders.
15
Gridlock Ltd has revenue of CU1.6m, cost of sales of CU0.9m and expenses of CU0.35m. Calculate the
following:
(a)
(b)
(c)
Gross margin
Net margin
Markup on cost of sales
6.4
Efficient use of resources is concerned with the economy with which resources are used, and the
effectiveness of their use in achieving the objective of the business.
Efficiency means being effective at minimum cost or controlling costs without losing operational
effectiveness. Efficiency is therefore a combination of effectiveness and economy.
Many businesses emphasise the importance of developing resources, capabilities and competencies that will
improve efficiency in the future, and so develop and measure critical success factors and key
performance indicators to show whether performance has been good in key areas.
6.5
CSFs differ from one business to another; in some areas of business price may be key, in others quality, in
others delivery, and so on.
CSFs concern not only the resources of the business but also the competitive environment in which it
operates. We shall come back to this in a later chapter.
6.6
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INTRODUCTION TO BUSINESS
17
Summary
Individuals
Other resources
Environment
Activity
Organisation
Size
Financing
Legal status
Owners
Orientation
PRIMARY
STAKEHOLDER
To provide goods/services
not-for-profit
To make
a profit
PRIMARY
OBJECTIVE
Profit maximisation
(or profit satisfaction,
revenue maximisation,
multiple objectives,
constraints)
Business
SECONDARY
OBJECTIVES
SECONDARY
STAKEHOLDERS
Directors
Managers
Employees
Customers
Suppliers
Lenders
Government
Local community
General public
Corporate
objectives
Market position
Product development
Technology
Human resources
Mission
Goals
Operational
objectives
= SMART
Profitability
Activity
Effectiveness
Economy
18
Resource use
Efficiency
Productivity
CSFs +
KPIs
Plans/standards
Performance and
measurement
Control action
INTRODUCTION TO BUSINESS
Self-test
Answer the following questions.
1
What is an organisation?
List four ways in which organisations may differ from each other.
A government funded agency exists to provide services to a group of beneficiaries. What would its
secondary objective be?
What is a business?
What three things are normally expected of a business by its suppliers as stakeholders?
State two possible primary business objectives other than profit/wealth maximisation.
Inch Ltd's operational objective for its Yem manufacturing division is 'increasing manufacturing
activities within a year'. On which one of the SMART criteria for objectives does this objective fall
down?
A
B
C
D
Specific
Measurable
Relevant
Time-bounded
Define productivity.
10
Define efficiency.
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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Answers to Self-test
1
An organisation is a social arrangement for the controlled performance of collective goals, which
has a boundary separating it from its environment
They may differ in terms of ownership (public or private), by whom their operations are
controlled (by owners or managers), what they do, whether they are oriented towards making a
profit, their size, their legal form (club, association, sole tradership, partnership, or company),
where they get their money from and what technology they use
A business is an organisation that is oriented towards making a profit for its owners but that can
be regarded as an entity separate from its owners
A business's mission is its basic function in society expressed in terms of how it satisfies its
stakeholders
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The objective is clearly time-bound and it is specific, as it is clear in which direction it wants
activities to go. Being related to manufacturing it can be said to be relevant. However, it gives no
indication of how the 'increase' is to be measured
Productivity is the quantity of goods or services produced in relation to the resources put into
their production
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INTRODUCTION TO BUSINESS
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