Consider the following media report: Tesco has warned its full-year

profits will be substantially below market expectations. The

supermarket chain said its group trading profit for the full financial year
will not exceed 1.4bn, far below the 1.8bn to 2.2bn range expected
by markets. Write a report describing how Tesco can improve its profit
performance.

On 12th December 2014, the share price of Tesco hit a 5 year low of 165.75 1, ending a sharp
fall which began in June 2014, as seen on the graph below; this fall in the share price depicts
a fall in consumer and investor confidence, and was brought about by a rapid increase in the
supply, and a fall in the demand, for Tesco shares. The question is therefore raised as to why
this rapid change occurred, and thus why the share price for Tesco PLC decreased sharply; an
answer can be found when looking at the forecast profit for Tesco during 2014. This essay
will aim to look at reasons behind the fall in profit, whilst using regular and alternate theory
of the firm, in order to analyse and suggest how Tesco can improve its profit performance.

1 http://www.tescoplc.com/index.asp?pageid=35

On 9th December 2014 Tesco announced that its 'group trading profit for the full financial
year "will not exceed 1.4bn" far below the 1.8bn to 2.2bn range expected by markets." 2;
the Tesco chief executive claimed that this fall in expected profit was mainly as a cause of
'changes to the way it deals with its suppliers' 3, along with the redundancy of 6000 staff.
Following regular consumer theory, we can state that the huge loss of profit during 2014
leads to a fall in the demand of Tesco for labour, thus reducing the wage rate and the quantity
of labour as shown on the graph below.

In turn behavioural economics suggests that this fall in the wage rate is likely to lead to a fall
in worker moral for remaining workers at Tesco; according to studies by Norsworthy and
Zabala in 1985 and 1990 a reduction in worker moral leads to an increase in unit cost 5.
Norsworthy and Zabala found that in the 1960's a fall in worker moral linked to the great
depression lead to a 2% unit cost increase per year in the automotive industry in the USA 6;
this suggests that a fall in worker morale could reduce productivity and thus increase the
2 http://www.bbc.co.uk/news/business-30391447
3 Ibid.
4 http://www.bized.co.uk/sites/bized/files/images/diagrams/small/ld_dec_mkt.gif
5 Norsworthy, J & Zabala, C. (1990). Worker Attitutudes and the Cost of
Production: Hypothesis Tests in an Equilibrium Model. Economic Inquiry. 28 1:5778.

costs of Tesco, resulting in smaller profits. If such a view is taken, Tesco could increase its
profit performance by working to improve worker morale and productivity, thus reducing
overall costs and increasing profits, as profit is equal to revenue minus cost.
However, traditional theory of the firm suggests that a fall in the labour force of a firm
actually reduces costs; in this theory there are only two inputs within the costs of the firm,
namely homogeneous labour and homogeneous capital. If the homogeneous labour cost falls
due to a reduction in the labour force of 6000 staff then Tesco costs fall and as such we may
not see profit performance fall, but perhaps even increase, as costs are decreased. This
depends greatly on whether the level of spending in store remains the same even with a fall in
the level of staff; if spending does not fall, and thus revenue of Tesco stays constant, Tesco
will see an increase in the profit performance due to a reduction in the cost of labour.
Furthermore we can analyse the fall in the labour force using the marginal product of labour
(MPL) and the marginal product of capital (MPK), namely the change in output given a small
change in the level of labour or capital respectively. Traditional theory of the firm implies that
if MPK is higher than MPL, a firm should reduce the level of labour in order to purchase
more capital, and the reverse if MPL is higher than MPK 7. In this case, we may see that the
reduction of the Tesco workforce by 6000 staff may already be a move by Tesco in order to
increase its profit performance, if instead of labour it wishes to purchase more capital in order
to take advantage of a high MPK as this will cause output to increase a large amount per extra
unit of capital, but only fall a small amount per unit of labour lost. If this is the case, Tesco
will see a reduction in the profit performance in the short-term as staff will need training in
6 Straka, J. (1993). Is Poor Worker Morale Costly to Firms?. ILR Review. 46 2:381394.
7 Barro, R. (1992). Capital Mobility in Neoclassical Models of Growth. NBER
Working Paper No. 4206. Published in The American Economic Review (1995) 85
1:103-115.

order to become more productive and thus increase output; for example if the money saved in
reducing the labour level by 6000 was invested by Tesco in new checkouts, the remaining
staff would need training in order to use the new checkouts productively. However in the
long-run, once the staff are able to use the new capital to its best potential, Tesco may see an
increase in profit performance again, assuming that MPK is higher than MPL.
From this basic micro-economic theory we are able to perhaps suggest a way in which Tesco
could increase profit performance. Above is an analysis which suggests that training of staff
could increase productivity with current capital, perhaps increasing the MPK in the long-run.
Further, Tesco may find that they gain employee loyalty through an increase in the training on
offer, Blundell claims that 'trained workers are much less likely to change or quit their jobs or
to be made redundant.'8; this suggests that increased investment from Tesco would likely
mean the firm could retain highly trained workers in the long-run, and thus see profit
performance increase exponentially depending on the level of training supplied by the
company to the workers. This is shown on the graph below, showing the learning curve of an
average worker; here we are able to see how by the 240th unit produced by a worker the time
needed falls from 40 hours to roughly 15 hours, thus showing that experience and training,
both of which give tacit knowledge and an increase in ability to produce the product
efficiently, can increase productivity.

8 Blundell, R. Dearden, L. Meghir, C. Sianesi, B. (1999). Human Capital

Investment: The Returns from Education and Training to the Individual, the Firm
and the Economy. Fiscal Studies 20 1:1-23.

However if Tesco were to offer an increased training programme to their employees, studies
suggest that general training programmes achieve higher increases in productivity than
specific training programmes. The ability of a training programme to achieve the purpose of
increasing productivity, through an increase in the MPK as workers are able to use capital
more efficiently, depends on joint effort from employee and employer; should Tesco provide
training to workers, the workers themselves must fully engage in the programme in order to
fully increase productivity. As rational agents, Tesco employees understand that they may not
be with their current employer for the rest of their working lives, especially given the current
climate that Tesco find themselves in. As such workers are much more likely to engage in
training which is transferable and makes them more employable in the future, namely general
training over specific training. One study suggests that 'Employees who receive general
training realize that it is useful outside the firm and are thus more likely to regard it as a gift.
They increase their effort in exchange, leading to increased productivity.'10.

9 http://4.bp.blogspot.com/f5Y1eHmqlQA/T6iaFNFhpNI/AAAAAAAAAW0/H7NEOoG2Hx4/s1600/learningcurve.jpg
10 Barrett, A. (2001). Does Training Generally Work? The Returns to in-Company
Training. ILR Review 54 3:647-662.

The Tesco chief executive gave the main reason for the fall in profit performance as a change
to the way Tesco deals with its suppliers. According to one theory the use of suppliers by big
supermarket chains such as Tesco is inevitable due to the impossibility of a supermarket
producing every single product that it sells within the firm; as such a supermarket must use
the knowledge that a supplier is able to offer. In this theory specialisation by a firm which
produces one good, such as the supplier Tesco may use for frozen goods, is a positive aspect
of the market, and one in which Tesco may find a way to increase profit performance. Hayek
suggested that the price mechanism produced when using the market, as Tesco does with its
suppliers, provides firms with a way in which they are able to avoid distributed knowledge 11.
For example, Tesco employees do not need to have an intimate knowledge with the current
state of potato crops in order to know that they will begin to sell less frozen chips; an increase
in the price level of frozen chips tells them they will sell less without the actual knowledge of
why. This suggests that in order to prevent situations in which an employee may be set a task
which they have less knowledge of than another, Tesco should use suppliers in order to fill
the shelves with goods, rather than producing the goods themselves. Further the relationship
with the supplier is not entirely impersonal as neoclassical theory may suggest; this stems
from the fact that the ability of a firm such as Tesco to 'provide competitive products of
services depend on the competencies of their supply chains'12. The fall in Tesco profit
performance may be accounted for when thinking of the idea that 'the characteristics of
companies' relationships influence what happens inside the companies themselves' 13
11 Hayek, F. (1945). The Use of Knowledge in Society. The American Economic
Review 35 4:519-530.
12 Krause, D. (1999). The Antecedents of Buying Firms' Efforts to Improve
Suppliers. Journal of Operations Management 17 2:205-224.
13 Ford, D. (2002). How Should Companies Interact in Business Networks. Journal
of Business Research 55 2:133-139.

suggesting that negative relationships with suppliers can lead to an increase in costs and as
such lead to a fall in profit performance. If this theory is to be believed, then a change to the
way Tesco deals with its suppliers could improve the relationship and therefore decrease costs
and increase profit performance.
Conversely alternative theory claims that large firms such as Tesco should use the fungible
knowledge possessed by managers, who now have no role in the firm due to the firm
reaching the bottom of its learning curve, in order to expand the business and produce the
products that it sells for itself. For Tesco this would mean that the managers have set up
sufficient roles and timetables such that the staff can stock shelves and manage the day to day
running of the store without any real input from the managerial team. At this point a firm may
see a fall in profit performance as a wage is being paid to the managers but they are not
increasing productivity. Some critics argue that at this point firms have two options: to let the
manager go or to provide an alternative role for the manager, namely diversification into
different markets; for example Tesco mobile was created as a branch for the firm into another
sector. This previous expansion into other markets by Tesco suggests that it is operating near
the bottom of the learning curve described above; as such Tesco may find an increase in
profit performance through expansion into other markets, thus removing the need for an
improvement in the relationship it has with its suppliers. By doing this, Tesco will gain the
maximum productivity out of the managers, whilst also foregoing the high legal costs
involved when setting up contracts with suppliers; however they will be faced with influence
and agency costs along with distributed knowledge. Influence costs, an idea originally
developed by Coase can be described as those costs incurred when employees of a firm aim
to influence decision making for their own private benefit 14. If these costs outweigh the
14 Roberts, J. (1990). Bargaining Costs, Influence Costs, and the Organisation of
Economic Activity. in Perspectives on Positive Political Economy. Cambridge:
University of Cambridge. Pp 58.

transaction costs, namely those legal contact costs, then it would not be beneficial for Tesco
to begin producing the products that it sells. However if the transaction costs are higher then
Tesco may be able to improve their profit performance by beginning to produce their own
products, putting to work the managers who currently have no role in the firm.
To conclude, the ability for Tesco to improve its profit performance depends greatly on the
position that Tesco currently finds itself in. Media sources suggest that Tesco is currently
training 'all 960 staff involved in supplier negotiations' 15; this tells us that Tesco aims to
continue to deal with suppliers and as such it is clear that for Tesco transaction costs are
lower than influence and agency costs. We can also question the ability of a supermarket
chain such as Tesco to produce its own goods due to the large range of goods that the firm
sells; as such it is possible to conclude that improving supplier relations will lead to lower
costs and thus improve the profit performance of Tesco. In order to improve this supplier
relation this report concludes that Tesco should improve the general training that it supplies to
its employees as this will ensure the greatest effort and reward on behalf of the labour force,
and thus improve productivity and in turn profit performance the greatest amount.
Furthermore the conclusion can be reached that improving worker morale after worries about
the large scale sacking in the firm, Tesco could achieve this through an increase in the wage
rate, however this would increase costs, or by working closer with workers to improve their
working conditions and contracts to ensure work in the future. An increase in worker morale
will lead to higher productivity, thus reducing costs and increasing profit performance. In
total it appears that Tesco are already implementing many of the possible profit performance
improvers that this report has suggested; this tells us that Tesco is committed to improving its

15 http://www.theguardian.com/business/2014/dec/09/tesco-share-price-falls500m-profit-plunge-dave-lewis

profit performance in the near future, with an aim to increase future profits and raise the
Tesco share price.

Bibliography
Barro, R. (1992). Capital Mobility in Neoclassical Models of Growth. NBER Working
Paper No. 4206. Published in The American Economic Review (1995) 85 1:103115.
Barrett, A. (2001). Does Training Generally Work? The Returns to in-Company
Training. ILR Review 54 3:647-662.
Blundell, R. Dearden, L. Meghir, C. Sianesi, B. (1999). Human Capital Investment:
The Returns from Education and Training to the Individual, the Firm and the
Economy. Fiscal Studies 20 1:1-23.
Ford, D. (2002). How Should Companies Interact in Business Networks. Journal of
Business Research 55 2:133-139.
Hayek, F. (1945). The Use of Knowledge in Society. The American Economic
Review 35 4:519-530.
Krause, D. (1999). The Antecedents of Buying Firms' Efforts to Improve Suppliers.
Journal of Operations Management 17 2:205-224.
Norsworthy, J & Zabala, C. (1990). Worker Attitutudes and the Cost of
Production: Hypothesis Tests in an Equilibrium Model. Economic Inquiry. 28 1:5778.
Roberts, J. (1990). Bargaining Costs, Influence Costs, and the Organisation of
Economic Activity. in Perspectives on Positive Political Economy. Cambridge:
University of Cambridge. Pp 58.
Straka, J. (1993). Is Poor Worker Morale Costly to Firms?. ILR Review. 46 2:381394.
http://www.bbc.co.uk/news/business-30391447
http://www.bized.co.uk/sites/bized/files/images/diagrams/small/ld_dec_mkt.gif
http://www.tescoplc.com/index.asp?pageid=35
http://www.theguardian.com/business/2014/dec/09/tesco-share-price-falls-500mprofit-plunge-dave-lewis
http://4.bp.blogspot.com/f5Y1eHmqlQA/T6iaFNFhpNI/AAAAAAAAAW0/H7NEOoG2Hx4/s1600/learningcurve.jpg